**SECURITIES ANDEXCHANGE COMMISSION**

**Washington, DC 20549**

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**FORM 10-K**

**ANNUAL REPORTPURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

**FOR THE FISCAL YEARENDED DECEMBER 31, 2005**

**COMMISSION FILE NUMBER: 1-14097**

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**SAUER-DANFOSS INC.**

(Exact name of registrant as specified in its charter)

| **Delaware**                             |   | **36-3482074**      |
|------------------------------------------|--------|---------------------|
| (State or other jurisdiction of          |   | (I.R.S. Employer    |
| incorporation or organization)           |   | Identification No.) |
| **250 Parkway Drive,  Suite 270,**  |   | ** **          |
| **Lincolnshire, Illinois**               |   | **60069**           |
| (Address of principal executive offices) |   | (Zip Code)          |

 

**(515) 239-6000**

(Registrant’s telephone number, including Area Code)

Securities registered pursuant toSection 12(b) of the Act:

|                       | Common Stock, par value  $0.01 per share |                                        |   |  | New York Stock Exchange |   |
|-----------------------|------------------------------------------|---------------------------------------------|--------|--|-------------------------|--------|
| (Title of each class) |                                     | (Name of each exchange on which registered) |

 

Securities registered pursuant toSection 12(g) of the Act:

| **None**         |
|------------------|
| (Title of class) |

 

Indicate by check mark if the registrant is awell-known seasoned issuer, as defined in Rule 405 of the Securities Actof 1933. Yes o No x

Indicate by check mark if the registrant is notrequired to file reports pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934 (the “Act”). Yes oNo x

Indicate by check mark whether the registrant: (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theAct during the preceeding 12 months (or for such shorter periods that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes xNo o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K is not contained herein, andwill not be contained, to the best of registrant’s knowledge, in definitiveproxy or information statements incorporated by reference in Part III ofthis Form 10-K or any amendment to this Form 10-K: x

Indicate by check mark whether the registrant is alarge accelerated filer, accelerated filer, or a non-accelerated filer. Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2of the Act. (Check one):

Large Accelerated Filer o         AcceleratedFiler x         Non-AcceleratedFiler o

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Act): Yes oNo x

The aggregate market value of the voting common stockof the registrant held by nonaffiliates based on the last sale price on June 30,2005 was $179,792,489. (The registrant does not have any other authorizedcommon equity.)

As of February 28,2006 there were 47,732,779 shares of common stock, $0.01 par value, of theregistrant outstanding.

**DOCUMENTSINCORPORATED BY REFERENCE**

Portions of the Proxy Statement for the annual meetingof stockholders to be held June 1, 2006 are incorporated by reference intoPart III.

 

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**PART I**

**Item 1.   Business.**

**(a)**         GeneralDevelopment of Business

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

**(b)**         FinancialInformation About Segments

The Company reports itsoperating segments based on its various product lines of Propel, Work Function,and Controls. Propel products include hydrostatic transmissions and relatedproducts that transmit the power from the engine to the wheel to propel avehicle. Work Function products include steering motors as well as gear pumpsand motors that transmit power for the work functions of the vehicle. Controlsproducts include electrohydraulic controls, microprocessors, electric drives,and valves that control and direct the power of a vehicle. Information aboutthe Company’s reportable segments defined by product lines is set forth inNote 17 in the Notes to Consolidated Financial Statements on pages F-31through F-33 of this report and is incorporated 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 17 in the Notes to ConsolidatedFinancial Statements on pages F-31 through F-33, and isincorporated herein by reference. No individual customer, OEM or other,accounted for 10 percent or more of the Company’s total net sales in 2005,2004, or 2003.

***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 transmissionsmanufactured by the Company include light agricultural and turf care mobileequipment. The Company manufactures these hydrostatic transmissions at itsfacilities in Ames, Iowa; Lawrence, Kansas; Sullivan, Illinois; Freeport,Illinois; LaSalle, Illinois; Neumunster, Germany; Dubnica nad Vahom, Slovakia;Povazská Bystrica, Slovakia; Shanghai, China; and Osaka, Japan.

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***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 itsLawrence, Kansas, and Nordborg, Denmark, facilities. These motors are used forboth the propel and work functions 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,Wroclaw, Poland, and Pune, India. These steering units convert steering wheelmotion into hydraulic flow and pressure to provide steering motion foragriculture tractors, 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; Redditch, United Kingdom; Cento, Italy; andNordborg, Denmark. Electrohydraulic controls and sensors integrate hydraulics,hydrostatic transmissions, and mechanical components with electronic controlsand are used by OEMs of mobile equipment to control the Company’s hydraulicsystems, 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, and power units through itselectric drives operations in Odense, Denmark and Berching, Germany. TheKaiserslautern, Germany, facility designs inverters used to control the AC electricmotors which are manufactured by the facility in Almhult, Sweden.

**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 forestry 

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and agriculturalharvesting equipment, to very simple low cost valves for turf care agriculturaltractors. These products are manufactured in facilities located in Caxias doSul, 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; Easley, South Carolina; and Caxias do Sul, Brazil. Aerial liftplatforms and road building equipment are significant users of cartridgevalves.

**MajorMarkets and Applications**

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

Sauer-Danfoss operates 25 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. The Companysells and distributes its products directly to large OEMs and serves smallerOEM’s through Company owned sales companies or independent 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 one 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 manufactures 

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products to order. TheCompany typically machines components with long lead times according to a salesforecast and machines certain unique components for specific customersaccording to firm orders. Inventories at the Company’s manufacturing sitesconsist primarily of raw materials and machined iron housings and components.Limited amounts of assembled finished units are maintained in inventory at themanufacturing sites. Certain of the Company’s sales locations maintaininventory that consist primarily of finished units manufactured specificallyfor distribution to customers in those locations.

The Company does notaccept orders subject to late delivery penalties. On occasion, the Companysells its products to government agencies, including those used for militaryapplications, but it does not design its products to meet specific governmentstandards and usually only enters into contracts for the supply of commercialproducts. There are no government contracts of material value to the Company.

**Raw Materials**

The Company purchases ironhousings and components from various U.S., European, and Asian foundries andmetal suppliers. The principal materials used by the Company are iron, steel,brass, and aluminum. All materials used by the Company are generally availablefrom a number of sources in quantities sufficient to meet current requirements.In 2004 and 2005 the availability of steel was limited, and although theCompany was able to obtain sufficient quantities of steel and castings to meetits production needs, the cost of these materials were higher than in the pastdue to limited supplies and metal surcharges. The Company has a global supplierquality program that is used by the Company to ensure all suppliers meet theCompany’s quality expectations.

**Patents, Trademarks, and Licenses**

The Company owns or licenses rights to approximately660 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 unaffiliated companies in certain countries. TheCompany does not currently have any such license agreements in place. TheCompany currently has license agreements in place as part of joint ventureagreements to which the company is a party, for the joint venture entity tomanufacture or distribute the Company’s technology.

**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 theyear. Seasonal demand must be estimated in advance, and products must bemanufactured in anticipation of such demand in order to achieve efficientutilization of labor and production resources.

**Backlog**

At December 31, 2005the Company’s backlog (consisting of accepted but unfilled customer ordersprimarily scheduled for delivery during 2006) was $487 million, anincrease of thirteen percent from December 31, 2004, excluding the impactof currency fluctuation. The amount of the Company’s backlog is significantbecause, among other factors, customer orders have historically involved longlead times and specific model types. Orders can be canceled or rescheduled bycustomers which would cause the backlog level to decline. In addition,customers’ ordering patterns can impact the level of reported backlog. For 

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example,the Company’s U.S. distributor customers are placing orders with shorter leadtimes due to the Company’s ability to fill 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 pricing at the component level. There areapproximately ten major companies that compete on a global basis, includingBosch Rexroth AG, Parker-Hannifin Corporation, and Eaton Corporation, and inJapan, Kayaba and Kawasaki. The supply of standard gear pumps and motors isparticularly fragmented with more than 50 companies worldwide in eachrespective area. Most of these competitors have a limited product range andoperate 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-Danfoss opportunityto 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 believes it has the largest European market sharefor steering units and a growing share globally. As steering systems grow andneeds expand, Sauer-Danfoss is providing electronic control of steering andcomplete electrical steering solutions to meet the growing demands of thesteering market. Today, Sauer-Danfoss believes that it leads the industry inthis direction for steering technology.

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*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 and controlsit is now well equipped to serve our customers in these segments with either ahydraulic solution or an electric solution for their propel and work functionneeds. The Company believes it is well positioned to establish itself as atechnology 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 2005, 2004, and 2003 were approximately $58.7million, $51.9 million, and $43.5 million, respectively.

**Environmental Matters**

In all countries in whichit operates, the Company is subject to environmental laws and regulationsconcerning emissions to air, discharge to waterways, and the generation,handling, storage, transportation, treatment, and disposal of waste materials.These laws and regulations are constantly evolving, and it is impossible to 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 environmentalissues that would have a materially adverse effect on the Company.

**Employees**

As of December 31,2005, 2004, and 2003 the Company had approximately 8,600, 8,300, and 7,400,employees, respectively. Of its full time employees at December 31, 2005,approximately 3,000 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.

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**FinancialInformation about Geographic Areas**

Information regarding theCompany’s net sales and long-lived assets by geographic area is set forth inNote 17 in the Notes to Consolidated Financial Statements on pages F-31through F-33 of this report, and is incorporated herein by reference.

**Available Information**

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

**Item 1A.   RiskFactors.**

The Company’s business,financial condition, results of operations and cash flows can be affected by anumber of factors, including but not limited to those set forth below andelsewhere in this annual report on Form 10-K, any one of which couldcause actual results to vary materially from recent results or from anticipatedfuture results.

**International Operations**

The Company depends on thestrength of the economies in various parts of the world, particularly in the U.S.and Europe. As a result of this worldwide exposure, net revenue andprofitability may be harmed as a result of economic conditions in the majormarkets in which the Company operates, including, but not limited to,recessions, inflation and deflation, general weakness in the agriculture, constructionand specialty markets, and changes in consumer purchasing power.

**Technology Change**

The hydraulic industry andmarkets for component parts of mobile hydraulics are subject to technologicalchange, evolving industry standards, changing customer requirements andimprovements in and expansion of product offerings. Although the Companybelieves that it has the technological capabilities to remain competitive,technological advances or developments by competitors or others could result inthe Company making significant capital expenditures in order to remaincompetitive and to avoid material adverse effects on its business, financialconditions and results of operations.

**Implementationof New Business System**

The Company is in theprocess of implementing a common business system at all locations. Anysignificant problems incurred related to this system implementation may delayor stop manufacturing and hinder the Company’s ability to ship product in atimely manner or affect the Company’s ability to access financial information.These problems could result in the loss of customers, a decrease in revenue orsignificant costs to correct the problem.

**Raw Material Availability**

The Company purchases raw materials and componentparts from suppliers to be used in the manufacture of products. Changes inrelationships with suppliers or increases in the costs of purchased rawmaterials including steel and other metals, and component parts could result inmanufacturing 

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interruptions, delays,inefficiencies, or the inability to market products. In addition, profitmargins would decrease if prices of purchased raw materials or component partsincrease and the Company is unable to pass on those increases to its customers.

**Pricingand Competitive Pressures from OEM Customers**

A majority of theCompany’s sales are directly to OEM customers. Increasingly, OEM customers areseeking to use their positions as volume purchasers in the mobile hydraulicsmarket to obtain preferential pricing and to obtain substantial qualityassurance protection from suppliers.

**Currency Exchange Rates**

The Company has a numberof manufacturing sites throughout the world and sells products in severalcountries other than those where the product is manufactured. As a result, the Companyhas exposure to movements in the exchange rates of various currencies againstthe U.S. dollar and against the currencies of countries in which the mainmanufacturing facilities are located. The Company’s most significant foreigncurrency exposures are the euro, pound sterling and Danish kroner. Exchangerate fluctuations relative to the U.S. dollar could adversely affect theCompany’s results of operations.

**Cyclicality:Risks Associated with General Economic Conditions**

The capital goods industryin general and mobile hydraulics industry in particular are subject to economiccycles. Cyclical downturns have in the past had and could in the future have amaterial adverse effect on the demand for the Company’s products and,consequently, on the Company’s business, financial condition, and results ofoperations. Demand for the Company’s products is dependent upon the generalcondition of the off-highway mobile equipment industry which may be affected bynumerous factors, including levels of construction activity, weather conditionsand interest rates. The Company’s results of operations are also subject toprice competition and the cost of supplies and labor, both of which areaffected by general economic conditions. The Company derives substantial salesfrom cyclical industries, including the turf care, material handling,construction and agricultural equipment industries. Periods of economic recessionin the U.S. or Europe or any other major industrial market could cause asubstantial decrease in the Company’s net sales and have a material adverseeffect on the Company’s business, financial conditions and results ofoperations.

**Income Tax Estimates**

The Company is subject toincome taxes in the U.S. and numerous non-U.S. jurisdictions. Significantjudgment is required in determining the worldwide provision for income taxes.In the ordinary course of business, there are many transactions andcalculations where the ultimate tax determination is uncertain. The Company isperiodically under audit by tax authorities. Although management believes taxestimates are reasonable, the final outcome of tax audits and any relatedlitigation could be materially different than that which is reflected inhistorical income tax provisions and accruals. Based on the status of a giventax audit or related litigation, a material effect on the Company’s income taxprovision or net income may result in the period or periods from initialrecognition in the Company’s reported financial results to the final closure ofthat tax audit or settlement of related litigation when the ultimate tax andrelated cash flow is known with certainty.

**Catastrophic Events**

Unforeseen events, including war, terrorism and otherinternational conflicts, public health issues, and natural disasters such asearthquakes, hurricanes or other adverse weather and climate conditions,whether occurring in the U.S. or abroad, could disrupt the Company’soperations, disrupt the operations of suppliers or customers, or result inpolitical or economic instability. These events could reduce demand for 

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hydraulic and electricproducts and make it difficult or impossible for the Company to manufactureproducts, deliver products to customers, or to receive products from suppliers.

The foregoing list is not exhaustive. There can be noassurance that the Company has correctly identified and appropriately assessedall factors affecting the Company or that the publicly available and otherinformation with respect to these matters is complete and correct. Additionalrisk and uncertainties not presently known to the Company or that are currentlybelieved to be immaterial also may adversely impact the business. Should anyrisks or uncertainties develop into actual events, these developments couldhave a material adverse effect on the Company’s business, financial condition,and results of operations.

**Item 2.   Properties.**

Sauer-Danfoss Inc.conducts its manufacturing operations at 25 locations; nine in the UnitedStates, three in Italy, two each in Germany, Denmark, and Slovakia, and oneeach in the United Kingdom, Brazil, China, India, Japan, Poland, and Sweden.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                              |       | 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     |             |       |
| Princeton, Kentucky               |         | Propel                              |       | 68,000                                                 |       |                                    | Owned      |             |       |
| 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      |             |       |
| 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                             |         |                                |       | 4,421,000                                              |       |                                    |       |             |       |

 

9

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**Item 3.   Legal Proceedings.**

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

**Item 4.   Submission of Matters to a Vote ofSecurity Holders.**

The Company did not submitany matter to a vote of security holders, through a solicitation of proxies orotherwise, during the fourth quarter of 2005.

**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)   |       |       | 58         |    |       | President  and Chief Executive Officer                  |       |                | 2000       |   |   |
| Hans J. Cornett  (1)     |       |       | 55         |    |       | Executive  Vice President — Sales and Marketing    |       |                | 2000       |   |   |
| Karl J. Schmidt  (2)     |       |       | 52         |    |       | Executive  Vice President and Chief Financial Officer   |       |                | 2002       |   |   |
| James R. Wilcox  (1)     |       |       | 60         |    |       | Executive  Vice President and Chief Operating Officer   |       |                | 2000       |   |   |
| Ronald C. Hanson  (3)    |       |       | 43         |    |       | Vice  President — Human Resources                  |       |                | 2003       |   |   |
| Thomas K. Kittel  (1)    |       |       | 57         |    |       | Vice  President — Propel Products                  |       |                | 2000       |   |   |
| Henrik Krabsen  (1)      |       |       | 44         |    |       | Vice  President — Valves                           |       |                | 2000       |   |   |
| Finn H. Lyhne (1)        |       |       | 51         |    |       | Vice  President — Work Function Products           |       |                | 2000       |   |   |
| Kenneth D.  McCuskey (1) |       |       | 51         |    |       | Vice  President and Chief Accounting Officer, Secretary |       |                | 2000       |   |   |
| Albert K. Zahalka  (1)   |       |       | 54         |    |       | Vice  President — Mobile Electronics               |       |                | 2000       |   |   |
| Charles M. Cohrs (4)     |       |       | 43         |    |       | Treasurer                                               |       |                | 2005       |   |   |

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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 joining theCompany, Mr. Schmidt was employed by Degussa-Huls Corporation as VicePresident and Chief Financial Officer.

(3)          Prior to joining theCompany, Mr. Hanson was employed by Maytag Corporation as Vice President,Human Resources.

(4)          Prior to joining theCompany, Mr. Cohrs was employed by Cable Design Technologies as Treasurer.

10

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**PART II**

**Item 5.   Market for the Company’s Common Stockand Related Stockholder Matters.**

*Market and DividendInformation*

The Company’s Common Stock is traded on the New YorkStock Exchange. Prior to February 2006, the Company’s common stock wasalso traded on the Frankfurt (Germany) Stock Exchange. As of February 28,2006, there were 233 stockholders of record.

The Company is currently paying a quarterly dividend,which is subject to Board of Directors approval. In the first quarter of 2006the Board of Directors approved paying a dividend of $0.14 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, 2004, and thequarterly cash dividends declared in 2005 and 2004:

| ** ** | ** ** | **1st** | ** ** | **2nd** | ** ** | **3rd** | ** ** | **4th** | ** ** | **Full  Year** | ** ** |
|------------|------------|---------|------------|---------|------------|---------|------------|---------|------------|----------------|------------|
| **2005**   |       |    |       |    |       |    |       |    |       |           |       |
| High       |       | $       | 24.20      |    | $          | 23.27   |       | $       | 20.77      |           | $          | 21.25 |   | $ | 24.20 |   |
| Low        |       | $       | 18.80      |    | $          | 16.99   |       | $       | 17.12      |           | $          | 17.34 |   | $ | 16.99 |   |
| Dividends  |       | $       | 0.12       |    | $          | 0.12    |       | $       | 0.12       |           | $          | 0.12 |   | $ | 0.48 |   |
| **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 |   |

 

11

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**Item 6.   Selected Financial Data.**

**SELECTED FINANCIALDATA**

| ** **                                   | ** ** | **2005**                                                                                | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|----------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| ** **                                   | ** ** | **(in millions except per share and employee data)** | ** ** |
| **Operating Data:**                          |       |                                                                                    |       |     |       |     |       |     |       |     |       |
| Net Sales                                    |       | $                                                                                       | 1,547.8    |     | $          | 1,404.2  |       | $        | 1,126.8    |     | $          | 952.3 |   | $ | 855.3 |   |
| Gross profit                                 |       | 357.7                                                                                   |       | 346.1    |       | 252.4    |       | 219.0    |       | 192.6    |       |
| Selling, general  and administrative         |       | 217.1                                                                                   |       | 200.2    |       | 156.7    |       | 128.6    |       | 122.8    |       |
| Research and  development                    |       | 58.7                                                                                    |       | 51.9     |       | 43.4     |       | 37.8     |       | 38.1     |       |
| Loss on disposal  of fixed assets            |       | 1.4                                                                                     |       | 2.1      |       | 5.3      |       | 0.4      |       | 0.6      |       |
| Total operating  expenses                    |       | 277.2                                                                                   |       | 254.2    |       | 205.4    |       | 166.8    |       | 161.5    |       |
| Total interest  expense, net                 |       | 15.7                                                                                    |       | 17.4     |       | 17.4     |       | 17.2     |       | 17.4     |       |
| Net income                                   |       | 38.7                                                                                    |       | 33.2     |       | 11.2     |       | 13.7     |       | 4.3      |       |
| **Per Share Data:**                          |       |                                                                                    |       |     |       |     |       |     |       |     |       |
| Income per common  share, basic              |       | $                                                                                       | 0.82       |     | $          | 0.70     |       | $        | 0.24       |     | $          | 0.29 |   | $ | 0.09 |   |
| Income per common  share, diluted            |       | $                                                                                       | 0.81       |     | $          | 0.70     |       | $        | 0.24       |     | $          | 0.29 |   | $ | 0.09 |   |
| Cash dividends  declared per share           |       | $                                                                                       | 0.48       |     | $          | 0.34     |       | $        | 0.28       |     | $          | 0.28 |   | $ | 0.28 |   |
| Weighted average  basic shares outstanding   |       | 47.5                                                                                    |       | 47.4     |       | 47.4     |       | 47.4     |       | 47.0     |       |
| Weighted average  diluted shares outstanding |       | 47.8                                                                                    |       | 47.5     |       | 47.5     |       | 47.4     |       | 47.0     |       |
| **Balance Sheet Data:**                      |       |                                                                                    |       |     |       |     |       |     |       |     |       |
| Inventories                                  |       | $                                                                                       | 245.4      |     | $          | 241.6    |       | $        | 198.9      |     | $          | 164.7 |   | $ | 141.7 |   |
| Property, plant  and equipment, net          |       | 450.4                                                                                   |       | 478.5    |       | 452.9    |       | 435.1    |       | 422.5    |       |
| Total assets                                 |       | 1,170.9                                                                                 |       | 1,211.6  |       | 1,101.8  |       | 970.5    |       | 884.3    |       |
| Total debt                                   |       | 332.3                                                                                   |       | 345.1    |       | 355.5    |       | 318.3    |       | 298.8    |       |
| Stockholders’  equity                   |       | 438.9                                                                                   |       | 444.1    |       | 397.2    |       | 367.3    |       | 345.8    |       |
| Debt to total  capital (1)                   |       | 40.4                                                                                    | %          | 41.6     | %          | 45.3     | %          | 44.7     | %          | 44.6     | %          |
| **Other Data:**                              |       |                                                                                    |       |     |       |     |       |     |       |     |       |
| Backlog (at  year-end)                       |       | $                                                                                       | 487.2      |     | $          | 450.4    |       | $        | 408.6      |     | $          | 382.8 |   | $ | 319.9 |   |
| Depreciation and  amortization               |       | 88.3                                                                                    |       | 82.4     |       | 80.4     |       | 72.6     |       | 69.9     |       |
| Capital  expenditures                        |       | 95.2                                                                                    |       | 79.3     |       | 60.0     |       | 42.3     |       | 69.7     |       |
| EBITDA (2)                                   |       | 172.3                                                                                   |       | 170.2    |       | 124.0    |       | 121.8    |       | 102.1    |       |
| Cash flows from (used  in):                  |       |                                                                                    |       |     |       |     |       |     |       |     |       |
| Operating activities                         |       | 116.3                                                                                   |       | 124.8    |       | 95.6     |       | 98.3     |       | 67.3     |       |
| Investing activities                         |       | (93.3                                                                                   | )          | (75.5    | )          | (65.0    | )          | (66.3    | )          | (110.1   | )          |
| Financing activities                         |       | (20.1                                                                                   | )          | (53.3    | )          | (28.8    | )          | (34.4    | )          | 33.5     |       |
| Number of employees (at  year end)           |       | 8,614                                                                                   |       | 8,275    |       | 7,409    |       | 7,207    |       | 6,790    |       |

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(1)          The debt to totalcapital 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.

(2)          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, capitalexpenditures, and 

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working capital requirements. The following tablefurther demonstrates how EBITDA is derived from cash flows from operatingactivities:

| ** **                                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows from  operating activities                                          |       | $        | 116.3      |     | $          | 124.8    |       | $        | 95.6       |     | $          | 98.3 |   | $ | 67.3 |   |
| Cumulative effect  of change in accounting principle                           |       | —   |       | —   |       | —   |       | (0.7     | )          | —   |       |
| Increase (decrease) in  working capital, excluding the effects of acquisitions |       |     |       |     |       |     |       |     |       |     |       |
| Accounts receivable, net                                                       |       | 4.8      |       | 30.8     |       | 5.6      |       | (2.8     | )          | (4.1     | )          |
| Inventories                                                                    |       | 24.3     |       | 24.3     |       | 7.6      |       | (1.1     | )          | (11.4    | )          |
| Accounts payable                                                               |       | 13.3     |       | (22.7    | )          | (6.1     | )          | (2.5     | )          | 16.5     |       |
| Accrued liabilities                                                            |       | (17.6    | )          | (10.2    | )          | (6.2     | )          | (4.1     | )          | (0.3     | )          |
| Deferred income taxes and other                                                |       | 4.5      |       | (9.9     | )          | 10.6     |       | 10.3     |       | 14.1     |       |
| Interest expense,  net                                                         |       | 15.7     |       | 17.4     |       | 17.4     |       | 17.2     |       | 17.4     |       |
| Tax expense  (benefit)                                                         |       | 11.0     |       | 15.7     |       | (0.5     | )          | 7.2      |       | 2.6      |       |
| EBITDA                                                                         |       | $        | 172.3      |     | $          | 170.2    |       | $        | 124.0      |     | $          | 121.8 |   | $ | 102.1 |   |

 

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**Item 7.   Management’s Discussion and Analysis ofFinancial Condition and Results 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 construction, road building,  and material handling markets specifically,continued to improve during 2005. It is difficult to determine if pastexperience is a good guide to the future. While the economy in the U.S. hasgenerally been improving, it remains unstable due to the uncertaintysurrounding continued job creation, interest rates, crude oil prices  and the U.S. government’s stance on theexchange rate of the dollar. The economic situation in Europe has notnecessarily followed the improvement that occurred in the U.S., and the economyin China was slow in 2005 due to government intervention, however there aresigns that the Chinese economy will improve in 2006. Any downturn in theCompany’s business segments could adversely affect the Company’s revenues andresults of operations. Other factors affecting forward-looking statementsinclude, but are not limited to, the following: specific economic conditions inthe agriculture, construction, road building, turf care, material handling andspecialty vehicle markets and the impact of such conditions on the Company’s customersin such markets; the cyclical nature of some of the Company’s businesses; theability of the Company to win new programs and maintain existing programs withits original equipment manufacturer (OEM) customers; the highly competitivenature of the markets for the Company’s products as well as pricing pressuresthat may result from such competitive conditions; the continued operation andviability of the Company’s significant customers; the Company’s execution ofinternal performance plans; difficulties or delays in manufacturing;cost-reduction and productivity efforts; competing technologies anddifficulties entering new markets, both domestic and foreign; changes in theCompany’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 

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manufacturers(OEMs) of mobile equipment, including construction, road building,agricultural, turf care, material handling, and specialty equipment. TheCompany designs, manufactures, and markets its products in the Americas,Europe, and the Asia-Pacific region, and markets its products throughout therest of the world either directly or through distributors.

**ExecutiveSummary of 2005 Compared to 2004**

Thenature of the Company’s operations as a global producer and supplier in thefluid power industry means the Company is impacted by changes in the localeconomies, including currency exchange rate fluctuations. In order to gain abetter understanding of the Company’s base results, a financial statement userneeds to understand the impact of those currency exchange rate fluctuations.The following table summarizes the change in the Company’s results fromoperations by separately identifying changes due to currency fluctuations andthe underlying change in operations from 2004 to 2005. This analysis is moreconsistent with how the Company’s management internally evaluates results.

| **(in millions)**                    | ** ** | ** ** | ** ** | **2004** | ** ** | **Currency  fluctuations** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2005** | ** ** |
|-------------------------------------------|------------|------------|------------|----------|------------|----------------------------|------------|--------------------------------------|------------|----------|------------|
| Net sales                                 |       | $          | 1,404.2    |     |       | $                          | 3.6        |                                 |       |     | $          | 140.0 |   |   | $ | 1,547.8 |   |
| Gross profit                              |       | 346.1      |       |     | 2.1        |                       |       |                                 | 9.5        |     |       | 357.7 |   |
| % of Net Sales                            |       | 24.6       | %          |     |       |                       |       |                                 |       |     |       | 23.1 | % |
| Selling, general  and administrative      |       | 200.2      |       |     | 0.1        |                       |       |                                 | 16.8       |     |       | 217.1 |   |
| Research and  development                 |       | 51.9       |       |     | 0.1        |                       |       |                                 | 6.7        |     |       | 58.7 |   |
| Loss on disposal  of fixed assets         |       | 2.1        |       |     | 0.0        |                       |       |                                 | (0.7       | )        |       | 1.4 |   |
| Total operating costs                     |       | 254.2      |       |     | 0.2        |                       |       |                                 | 22.8       |     |       | 277.2 |   |
| Operating income                          |       | 91.9       |       |     | 1.9        |                       |       |                                 | (13.3      | )        |       | 80.5 |   |
| % of Net Sales                            |       | 6.5        | %          |     |       |                       |       |                                 |       |     |       | 5.2 | % |
| Net interest  expense                     |       | (17.4      | )          |     | 0.0        |                       |       |                                 | 1.7        |     |       | (15.7 | ) |
| Other expense,  net                       |       | (4.1       | )          |     | 0.0        |                       |       |                                 | 7.6        |     |       | 3.5 |   |
| Income before taxes and minority interest |       | 70.4       |       |     | 1.9        |                       |       |                                 | (4.0       | )        |       | 68.3 |   |
| Minority interest                         |       | (21.5      | )          |     | 0.0        |                       |       |                                 | 2.9        |     |       | (18.6 | ) |
| Earnings before taxes                     |       | 48.9       |       |     | 1.9        |                       |       |                                 | (1.1       | )        |       | 49.7 |   |
| % of Net Sales                            |       | 3.5        | %          |     |       |                       |       |                                 |       |     |       | 3.2 | % |
| Income tax benefit (expense)              |       | (15.7      | )          |     | 1.0        |                       |       |                                 | 3.7        |     |       | (11.0 | ) |
| Net income                                |       | $          | 33.2       |     |       | $                          | 2.9        |                                 |       |     | $          | 2.6 |   |   | $ | 38.7 |   |

 

The underlying growth in sales, excluding the effectof currency fluctuations, was approximately 10 percent in 2005. The improvingeconomy in the U.S., not only resulted in increased sales within the Americas,but also increased export business from the Company’s European and Asia-Pacificcustomers. Margin on total net sales decreased due to several factors,including labor costs for overtime worked to meet the high demand for product,costs to expedite product to meet customer demand, and costs for subcontractsuppliers used to reduce the cost of production bottlenecks, primarily in theWork Function segment.

The increase in selling, general, and administrativecosts in 2005 is due to the continuing development and implementation of acommon business system to standardize business processes and provide a singleinterface to direct OEM customers and suppliers. The new business system hasbeen in development since 2003 and the costs incurred in 2004, with theexception of $3.5 million, related to development and therefore werecapitalized. The common business system was implemented at five locationsduring 2005 and costs related to the system and its implementation are nowexpensed. Costs in 2005 related to the 

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common business systemtotaled $23.0 million, of which $5.8 million are of an ongoing nature that willreplace costs related to the current systems in place. In future years it isanticipated that the investment in the common business system will driveimproved operational efficiency, customer service, and thereby improvefinancial performance. The system will continue to be implemented at additionallocations until complete in 2008. The Company incurred $4.4 million of expensein 2004 to restructure its sales and distribution operations in Europeresulting in consolidated inventory, warehouse, and distribution operations aswell as streamlined delivery directly from the manufacturing locations to thecustomer. There were no additional costs related to this restructuring in 2005.

Research and development costs increased approximately13 percent in 2005, due to ongoing research projects, primarily related to thePropel and Controls segments.

In 2005 the Companyrecognized other income of $3.2 million related to foreign currency gains ontransactions. The Company recognized $4.1 million of expense in 2004 due toforeign currency losses on transactions. This fluctuation between years wasprimarily due to the significant weakening of the U.S. dollar in late 2004 andthe strengthening of the U.S. dollar throughout 2005.

**OperatingResults — 2005 Compared to 2004**

***Sales Growth 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 ofcurrency fluctuations.

| ** **                  | ** ** | **Americas** | ** ** | **Asia-Pacific** | ** ** | **Europe** | ** ** | **Total** | ** ** | ** ** |
|-----------------------------|------------|--------------|------------|------------------|------------|------------|------------|-----------|------------|------------|
| Agriculture/Turf  Care      |       |         | 1          | %                |       |       | 28         | %         |       |       | 4 | % |   |   | 3 | % |   |   |
| Construction/Road  Building |       |         | 20         |             |       |       | 29         |      |       |       | 10 |   |   |   | 17 |   |   |   |
| Specialty                   |       |         | 30         |             |       |       | 5          |      |       |       | 11 |   |   |   | 14 |   |   |   |
| Distribution                |       |         | 14         |             |       |       | 2          |      |       |       | 7 |   |   |   | 10 |   |   |   |

 

*Agriculture/TurfCare*

The Asia-Pacific regionshowed the greatest percentage of growth, however this is a relatively smallmarket as it represents less than five percent of the Company’s sales in theagriculture and turf care markets. The agriculture market in the Americas wasdown overall; however, increased sales in the North American sprayer marketoffset reduced tractor production. The consumer turf care market in theAmericas was level with 2004, while demand in the commercial market was lowerthan in 2004. The agriculture market in Europe was also down compared to 2004resulting in reduced tractor sales. The agriculture market in Europe is notexpected to improve in 2006 and therefore certain OEMs are reducing inventoryand phasing out older product models.

*Construction/RoadBuilding*

The construction and roadbuilding markets were improved in the Americas in 2005. The 20 percent growthin the Americas is primarily due to a strong market for skid steer loaders;however, sales also increased due to new sales of medium power hydrostaticproducts to a major OEM in 2005. The 29 percent growth in Asia-Pacific is alsodue to strong markets for skid steer loaders and road roller products in NorthAmerica as the OEMs are exporting product to the Americas. The transit mixermarket drove the growth in the European market in 2005, in addition to OEMsexporting product to the Americas for the road building market.

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*Specialty*

A strong aerial liftmarket is contributing to the 30 percent growth in the Americas. In Europeseveral of the material handling markets experienced growth in 2005 includingforklift, aerial lifts, and container handling equipment. The forestry andmarine markets have also contributed to the 11 percent growth in the Europeanspecialty markets. The sales growth in the Asia-Pacific region is due toincreased sales into the mining market, although Asia-Pacific sales are a smallpercentage of the Company’s total sales in the specialty markets.

*Distribution*

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

***OrderBacklog***

The following table showsthe Company’s order backlog and orders written activity for 2004 and 2005,separately identifying the impact of currency fluctuations. In 2005 the Companychanged its methodology of recording backlog for a few of its larger customers.Under the revised approach the Company no longer includes customers’ forecastedamounts in backlog. The 2004 amounts have been revised to reflect this change.Order backlog represents the amount of customer orders received for futureshipment.

| **(in millions)**       | ** ** | ** ** | ** ** | **2004** | ** ** | **Currency   Fluctuation** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2005** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|---------------------------------|------------|--------------------------------------|------------|----------|------------|
| **Americas**                 |       |       |       |     |       |                            |       |                                 |       |     |       |   |   |
| Backlog at  December 31 |       | $          | 228.2      |     |       | $                               | 0.3        |                                 |       |     | $          | 58.7 |   |   | $ | 287.2 |   |
| Orders written               |       | 619.3      |       |     | 2.5        |                            |       |                                 | 132.4      |     |       | 754.2 |   |
| **Asia-Pacific**             |       |       |       |     |       |                            |       |                                 |       |     |       |   |   |
| Backlog at  December 31 |       | 18.2       |       |     | (1.0       | )                               |       |                                 | 6.5        |     |       | 23.7 |   |
| Orders written               |       | 101.1      |       |     | (0.4       | )                               |       |                                 | 25.9       |     |       | 126.6 |   |
| **Europe**                   |       |       |       |     |       |                            |       |                                 |       |     |       |   |   |
| Backlog at  December 31 |       | 204.0      |       |     | (21.3      | )                               |       |                                 | (6.4       | )        |       | 176.3 |   |
| Orders written               |       | 709.0      |       |     | 1.5        |                            |       |                                 | 40.4       |     |       | 750.9 |   |
| **Total**                    |       |       |       |     |       |                            |       |                                 |       |     |       |   |   |
| Backlog at  December 31 |       | 450.4      |       |     | (22.0      | )                               |       |                                 | 58.8       |     |       | 487.2 |   |
| Orders written               |       | 1,429.4    |       |     | 3.6        |                            |       |                                 | 198.7      |     |       | 1,631.7 |   |
|                              |            |            |            |          |            |                                 |            |                                      |            |          |            |  |  |  |  |  |  |  |  |

 

Total order backlog at the end of 2005 was $487.2 million,compared to $450.4 million at the end of 2004. On a comparable basis,excluding the impact of currency fluctuation, order backlog increased 13 percentover 2004. New sales orders written for 2005 were $1,631.7 million, an increaseof 14 percent over 2004, excluding the impact of currency fluctuations.

In recent years backlog information has become lessreliable as an indicator of future sales levels as customers alter their salesorder patterns. The 14 percent increase in orders written in 2005 is reflectiveof the strong sales experienced during the year and backlog remains strong atthe end of the year with over $480 million of customers orders received forfuture delivery.

***Business Segment Result***

The following discussion of operating results byreportable segment relates to information as presented in Note 17 in theNotes to Consolidated Financial Statements. Segment income is defined as therespective segment’s portion of the total Company’s net income, excluding netinterest expense, income 

17

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taxes, minority interest,and global service expenses. Propel products include hydrostatic transmissionsand related products that transmit the power from the engine to the wheel topropel a vehicle. Work Function products include steering motors as well asgear pumps and motors that transmit power for the work functions of thevehicle. Controls products include electrohydraulic controls, microprocessors,electric drives and valves that control and direct the power of a vehicle. Thefollowing table provides a summary of each segment’s net sales and segmentincome, separately identifying the impact of currency fluctuations during theyear.

| **(in millions)**                   | ** ** | ** ** | ** ** | **2004** | ** ** | **Currency  fluctuation** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2005** | ** ** |
|------------------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|--------------------------------------|------------|----------|------------|
| **Net sales**                            |       |       |       |     |       |                      |       |                                 |       |     |       |   |   |
| Propel                                   |       | $          | 656.5      |     |       | $                         | 0.7        |                                 |       |     | $          | 93.9 |   |   | $ | 751.1 |   |
| Work Function                            |       | 412.1      |       |     | 1.2        |                      |       |                                 | 17.4       |     |       | 430.7 |   |
| Controls                                 |       | 335.6      |       |     | 1.7        |                      |       |                                 | 28.7       |     |       | 366.0 |   |
| **Segment income (loss)**                |       |       |       |     |       |                      |       |                                 |       |     |       |   |   |
| Propel                                   |       | $          | 90.0       |     |       | $                         | 0.6        |                                 |       |     | $          | 15.8 |   |   | $ | 106.4 |   |
| Work Function                            |       | 20.8       |       |     | 0.7        |                      |       |                                 | (15.2      | )        |       | 6.3 |   |
| Controls                                 |       | 24.7       |       |     | 0.3        |                      |       |                                 | 6.4        |     |       | 31.4 |   |
| Global Services  and other expenses, net |       | (47.7      | )          |     | 0.3        |                      |       |                                 | (12.7      | )        |       | (60.1 | ) |

 

*Propel Segment*

*The Propel segment experiencedthe strongest growth in 2005, with a sales increase of 14 percent excluding theeffects of currency fluctuations. Consumers continue to move away frommechanical transmissions to hydrostatic transmissions in the turf care market,which has contributed to increased sales in the Propel segment, although, asnoted in the market section, the growth in the turf care market is beginning tolevel off. The gross profit percentage of sales in the Propel segment wasconsistent in 2005 with the 25 percent achieved in 2004. Segment income increased18 percent from 2004, excluding the effects of currency fluctuations.*

*Work FunctionSegment*

*Sales in the Work Functionsegment increased by 4 percent, excluding the effect of currency fluctuations,in 2005 compared to 2004. Similar to 2004, demand for Work Function product hasbeen high and has resulted in increased overtime costs and increased deliverycosts to expedite shipments to meet customer demand which has had a negativeimpact on the gross margin. In late 2005 the Company established productioncapacity in the U.S. for Work Function products that are sold in the U.S.market. This additional production capability is expected to reduce capacityconstraints and freight costs in 2006. During 2005 the Work Function segmentrecognized $1.0 million of field recall costs related to two separate qualityissues. In 2004 the income of the Work Function segment was negatively affectedby $2.2 million of restructuring costs, including the remaining costs torelocate the operations of the Company’s West Branch, Iowa facility that wasstarted in 2003.*

*Controls Segment*

*Net sales increased 8 percent,excluding the effects of currency fluctuations, in 2005 compared to 2004. Grossprofit as a percent of sales was consistent with 2004 at 28 percent. Segmentincome in 2005 increased 26 percent compared to 2004 excluding the impactof currency fluctuations.*

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*Global Services andother expenses, net*

Segment costs in Global Services and other expenses,net relate to internal global service departments, along with the operatingcosts of the Company’s executive offices. Global services include costs such asconsulting for special projects, tax, and accounting fees paid to outside thirdparties, certain insurance premiums, and the amortization of intangible assetsfrom certain business combinations. Expenses in global services increased in2005 due to $19.5 million of increased expenses related to the common businesssystem. This increased expense was partially off-set by a $7.3 millionfluctuation in foreign currency gain/loss and a $1.5 million reduction inoutside service costs to assess internal controls and related audit costs totest management’s assessment of internal control under Section 404 of theSarbanes-Oxley Act of 2002. Total costs in 2005 related to the internal controlassessment were $5.2 million in 2005, compared to $6.7 million in 2004. Asnoted in the executive summary, the Company recognized other income of $3.2million related to foreign currency gains on transactions in 2005 compared to$4.1 million of losses on foreign currency exchange in 2004, which is includedin global services and other expenses. 

***IncomeTaxes***

The Company’s effective tax rate was 22.1 percent in2005 compared to 32.2 percent in 2004.

The 2005 rate includes thebenefit of the reduction of the statutory tax rate in Denmark from 30 percentto 28 percent that was enacted in 2005. This change in tax rate resulted in adecrease of tax expense of $0.4 million for current year income and $1.1million for the change in deferred tax liabilities related to earlier periodsfor a total benefit of $1.5 million. The benefit was partially offset by $0.8million of tax expense in the U.S. related to the repatriation of previouslyundistributed earnings from a subsidiary in Denmark, in connection with theAmerican Jobs Creation Act. The 2005 rate also includes benefit of $4.4 millionfor reversal of valuation allowances on deferred tax assets. These deferred taxassets were generated in prior years and no tax benefits were recognized atthat time.

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**ExecutiveSummary of 2004 Compared to 2003**

The following tablesummarizes the change in the Company’s results from operations by separatelyidentifying changes due to currency fluctuations, acquisitions, and theunderlying change in operations from 2003 to 2004. This analysis is moreconsistent with how the Company’s management internally evaluates results.

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

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(1)          Consists of three monthsof operations of Comatrol, which was acquired in April 2003 and theresults of a Japanese manufacturing location which was accounted for under theequity method of accounting in 2003.

The underlying growth insales, which excludes the effect of currency fluctuations and acquisitions,exceeded 17 percent in 2004, in large part due to the improving economy in theU.S., which not only results in increased sales within the Americas, but alsoincreased export business from the Company’s European and Asia-Pacificcustomers. The Company’s sales growth exceeded the market growth of12 percent, which the Company determined based on the volume of units soldin the regions in which the Company distributes its products. In the secondhalf of 2004, the Company passed the increased cost of metals used in themanufacture of its products on to its customers, resulting in additionalrevenue of approximately $11.0 million in 2004. Margin on total net salesincreased over two percentage points due to several factors, includingspreading the fixed production costs over a higher volume of units produced,reduced field recall costs, and beginning to realize the benefits of therestructurings which have occurred in recent years. Management of the Companygenerally targets overall margin improvement of 20 to 25 percent on eachdollar of incremental sales based on the cost structure it has in place and theintent of reinvesting in the business for future growth. This target was met in2004 as the margin on the underlying increase in net sales exceeded 36 percent.

The Company continues topursue lean manufacturing efficiencies and expand the use of Six-Sigma qualitytools to reduce waste and improve processes throughout the Company. The Company’scontinuing focus on quality reduced the level of field recalls in the currentyear with no individually significant field 

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recalls in 2004. In 2003the Company incurred expense of $6.2 million on a pre-tax basis due to fiveunrelated field recalls. Increased emphasis on global logistics, selectiveoutsourcing, lower-cost manufacturing methods, and a consolidated network ofauthorized service centers also contributed to the gross margin improving to24.6 percent in 2004.

The Company achievedimproved profit margins in 2004, however increased operating costs partiallyoffset the increased gross profit. In 2004 the Company incurred a total of $6.8million of restructuring costs on a pre-tax basis related to the European salesand distributions operation, discussed below, and reorganization at certainproduction locations. The management rationalization within the Work Functionsegment, partial consolidation of the non-manufacturing functions of theControls segment within the U.S. and completion of the relocation of the WestBranch, 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.

The following tablesummarizes the significant costs, on a pretax basis, included in the selling,general, and administrative line that contributed to the $31.8 million increasein 2004 compared to 2003. Discussion of each item is included in the previousparagraph 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. It is expected that theinvestment in the common business system will contribute to improvedoperational efficiency in future years after it is implemented at all Companylocations.

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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**OperatingResults — 2004 Compared to 2003**

***Sales Growth 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/Turf  Care      |       |         | 25         | %                |       |       | 54         | %         |       |   | (1 | )% |   |   | 17 | % |   |
| Construction/Road  Building |       |         | 36         |             |       |       | 9          |      |       |   | 16 |   |   |   | 22 |   |   |
| Specialty                   |       |         | 36         |             |       |       | 37         |      |       |   | 16 |   |   |   | 20 |   |   |
| Distribution                |       |         | 23         |             |       |       | 15         |      |       |   | 7 |   |   |   | 15 |   |   |

 

*Agriculture/TurfCare*

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 allproducts. Although Asia-Pacific provides a smaller portion of the Company’ssales in the agricultural market than the Americas and Europe, the 54 percentincrease in 2004 sales represents continuing growth in this region, primarilyin Japan. The agriculture market in Europe remained flat in 2004, althoughsales growth did occur in the fourth quarter due to increased sales to severalOEMs. The consumer zero-turn radius machines continue to gain market sharefrom traditional lawn and garden tractors, which has led to increased sales ofthe Company’s new zero-turn transaxle product that was introduced late in 2003.In addition, the Company experienced market share gains from sales of lowspeed, high torque motors produced in its Nordborg, Denmark, facility.

*Construction/RoadBuilding*

Sales within theconstruction market increased in the Americas due to a combination of increasedproduction by OEMs and share growth as Sauer-Danfoss began to supply allhydraulic system content on an application produced by a large OEM, includingproduct previously supplied by a competitor. The Americas road building marketexperienced strong growth in 2004 with sales growth to all OEMs. TheCompany experienced 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. Key customers in the Asia-Pacific regionare located in China so the government economic restrictions in place duringthe last half of the year had a negative effect on sales growth; however,growth was strong in the first half of the year, resulting in growth for thefull year of 9 percent. Exports also generated additional sales in the Europeanregion. Demand for transit mixers has had a positive effect on the Europeansales in the construction and road building markets. Sales to several Europeancustomers experienced strong growth in the fourth quarter of 2004.

*Specialty*

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.

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***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. In 2005 the Company changed their methodology of recordingbacklog for a few of their larger customers. Under the revised approach theCompany no longer includes customers’ forecasted amounts in backlog. The 2004and 2003 amounts have been revised to reflect this change. Order backlogrepresents the amount of customer orders received for future shipment.

| **(in millions)**       | ** ** | ** ** | ** ** | **2003** | ** ** | **Currency  fluctuation** | ** ** | **Acquisitions** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2004** | ** ** |
|------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|------------------|------------|--------------------------------------|------------|----------|------------|
| **Americas**                 |       |       |       |     |       |                      |       |             |       |                                 |       |     |       |   |   |   |   |
| Backlog at  December 31 |       | $          | 182.9      |     |       | $                         | 0.3        |             |       |                                 | $          | —   |       |   |   | $ | 45.0 |   |   | $ | 228.2 |   |
| Orders written               |       | 481.9      |       |     | 0.9        |                      |       |             | —     |                                 |       |     | 136.5      |   |   | 619.3 |   |
| **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 |       | 367.1      |       |     | 18.0       |                      |       |             | 1.1        |                                 |       |     | 64.2       |   |   | 450.4 |   |
| Orders written               |       | 1,125.8    |       |     | 70.0       |                      |       |             | 12.6       |                                 |       |     | 221.0      |   |   | 1,429.4 |   |
|                              |            |            |            |          |            |                           |            |                  |            |                                      |            |          |            |  |  |  |  |  |  |  |  |  |  |  |

 

Total order backlog at the end of 2004 was$450.4 million, compared to $367.1 million at the end of 2003, anincrease of 23 percent. On a comparable basis, excluding the impact ofcurrency fluctuation and acquisitions, order backlog increased 18 percent over2003. New sales orders written for 2004 were $1,429.4 million, an increaseof 27 percent from 2003. Excluding the impact of currencies andacquisitions, total orders written in 2004 were 20 percent above the 2003levels.

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.

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***Business Segment Results***

Thefollowing table provides a summary of each segment’s net sales and segmentincome, separately identifying the impact of currency fluctuations andacquisitions 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      |       |   |   | $ | 31.7 |   |   | $ | 90.0 |   |
| Work Function                            |       | 9.3        |       |     | (1.0       | )                         |       |                      | —     |                                 |       |     | 12.5       |   |   | 20.8 |   |
| Controls                                 |       | 13.7       |       |     | 0.1        |                      |       |                      | 0.7        |                                 |       |     | 10.2       |   |   | 24.7 |   |
| Global Services  and other expenses, net |       | (29.5      | )          |     | (2.4       | )                         |       |                      | —     |                                 |       |     | (15.8      | ) |   | (47.7 | ) |

----

(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 in the economy contributed toincreased sales as demand from large OEMs and distributors increased. Increasedsales of $40.0 million in the America’s turf care market also contributed tothe sales increase as consumers continue to move away from mechanicaltransmissions to hydrostatic transmissions. Sales, excluding increases due tofluctuations in currency and acquisitions, increased by 25 percent in 2004compared to 2003 due to both increased sales volumes and prices.

The Propel segmentconverted the 25 percent underlying increase in sales to an increase in segmentincome of 63 percent, excluding the impact of currency fluctuations andacquisitions. This $31.7 million increase in underlying segment income is 25 percentof the underlying sales increase, meeting the Company’s internal expectations.The increase in segment income was partly due to spreading fixed costs over ahigher volume of units produced. However, the Company has also continued toidentify process improvements and cost reduction opportunities through the useof Six-Sigma quality tools and the pursuit of lean manufacturing efficiency. Inrecent years Propel segment income has been negatively impacted by increasedprice pressures due to customers demanding price concessions. In 2004 a focuson global purchasing initiatives reduced material costs by sourcing componentsto global suppliers who were more cost effective than previous suppliers and tooutsource the manufacturing of components when it was cost effective to do so.In 2003 the Propel segment incurred $5.2 million of field recall costs as aresult of four separate quality issues. The Company focused on revisingprocesses to reduce the level of field recall costs which contributed to theimproved segment income in 2004.

*Work FunctionSegment*

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 

24

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beginningto be realized from this restructuring. In 2003 the Company incurredapproximately $7.4 million of costs related to the relocation of operationsfrom its facilities in Sturtevant, Wisconsin, and West Branch, Iowa, to itslocations in Nordborg, Denmark; Wroclaw, Poland; Freeport, Illinois; andLawrence, Kansas. The relocation of the West Branch location was completed in2004, which, combined with additional reorganization within the Work Functionsegment, resulted in approximately $2.2 million of restructuring costs in 2004.In connection with the restructuring, the Company rationalized and outsourcedcertain low-volume product lines which is also contributing to the improvedsegment income in the current year. Segment income in 2004, excluding theeffect of currency fluctuations and acquisitions, more than doubled from the2003 level. The increased segment income derived from the underlying salesgrowth amounted to over 32 percent of the incremental sales growth, achievingmanagement expectations.

*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 $10.2 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 andother expenses, net*

The $15.8 million increasein Global Services and other expenses 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 requirements todocument and test internal controls under Section 404 of theSarbanes-Oxley Act of 2002 were $6.7 million in 2004, an increase of $6.2 millioncompared 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 resulted in alower effective tax rate.

**Market**Risk**

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

***Foreign Currency Changes***

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.

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In previous years, the Company had been well balancedbetween its U.S. and European operations because the Company generated itssales in the same country in which it incurred its expenses, or shippedproducts between geographic regions on a balanced basis. However, in recentyears the balance has shifted and the amount of sales made in U.S. dollars hasincreased, whereas the production costs are in a currency other than the U.S.dollar, increasing the Company’s exposure to transaction risk. In 2005 theCompany sold a total of $145.9 million into the U.S. of product that hadbeen produced in European based currencies compared to sales into Europe of$45.7 million of product produced in U.S. dollars. This imbalance had asignificant impact on the bottom line results of the Company. In 2005 the resultswere favorable as the dollar became stronger in comparison to other currenciescompared to 2004. The Company produces and sells its product in several regionsof the world, however the U.S. and European transactions comprise the majorityof the imbalance between regions.

In 2005 the Company began to enter into forwardcontracts to minimize the impact of currency fluctuations on cash flows relatedto forecasted sales denominated in currencies other than the functionalcurrency of the selling location. The forecasted sales represent sales to bothexternal and internal parties. Any effects of the forward contracts related tosales to internal parties are eliminated in the consolidation process until therelated inventory has been sold to an external party. The forward contractsqualify for hedge accounting and therefore are subject to effectiveness testingat the inception of the contract and throughout the life of the contract. Thefair value of forward contracts outstanding at December 31, 2005 was notsignificant. In 2006 the Company plans to enter into additional forwardcontracts to offset the risk of fluctuations in the currency exchange rateshaving a significant impact on the financial results of the Company.

TheCompany is also impacted by translation risk in terms of comparing results fromperiod to period. Fluctuations of currencies against the U.S. dollar can besubstantial and therefore, significantly impact comparisons with prior periods.The translation impact on making prior period comparisons with respect to theCompany’s net sales can be material. Translation affects the comparability ofboth the income statement and the balance sheet. As shown in the table below,the translation impact on net sales has been significant in recent years, withthe exception of 2005 as the average exchange rate for the full year in 2005was comparable to 2004.

| ** **                           | ** ** | **Percentage Sales Growth  Over Prior Year** | ** ** |
|--------------------------------------|------------|------------------------------------------------------------------|------------|
| ** **                           | ** ** | **  2005  **                                 | ** ** | **  2004  ** | ** ** | **  2003  ** | ** ** |
| As Reported                          |       |                                                             | 10.2       | % |   |   | 24.6 | % |   |   | 18.3 | % |   |
| Without Currency  Translation Impact |       |                                                             | 10.0       |   |   |   | 18.5 |   |   |   | 8.7 |   |   |

 

The change in the exchange rate does affect thecomparability of the balance sheet between 2005 and 2004 as the balance sheetaccounts are translated at the exchange rate as of December 31. The U.S.dollar strengthened by 13 percent against the euro from December 31,2004 to December 31, 2005. The U.S. dollar weakened against the euro in2004 and 2003 by 8 percent and 20 percent, respectively. The strengtheningof the dollar has resulted in approximately 40 percent of the Company’s totalbalance sheet being stated 13 percent lower than the prior year since roughly40 percent of the Company’s total assets and liabilities are denominated in theeuro.

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***Interest Rate 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 at December 31,2005, with a combined notional amount of 6.8 million euro, that require theCompany to pay interest at a fixed rate and receive interest at a variablerate. The fair value of the interest rate swap agreements is recorded as aliability of $0.3 million on the balance sheet at December 31, 2005, withthe offset recorded in accumulated other comprehensive income as thederivatives are accounted for using hedge accounting. The interest rate swapagreements mature at various dates 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** | ** ** |
|------------|------------|------------------------------------|------------|------------------------------|------------|
| 2006       |       |                               | $          | 13.9                         |       |   |   | $ | 154.6 |   |   |
| 2007       |       |                               | 7.2        |                         |       |   | 5.7 |   |   |
| 2008       |       |                               | 14.2       |                         |       |   | — |   |   |
| 2009       |       |                               | 13.1       |                         |       |   | — |   |   |
| 2010       |       |                               | 14.7       |                         |       |   | — |   |   |
| Thereafter |       |                               | 80.6       |                         |       |   | — |   |   |
| Total      |       |                               | $          | 143.7                        |       |   |   | $ | 160.3 |   |   |

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(1)          Includestotal principal repayments of $8.0 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 beencash flow from operations and from its various credit facilities. The Companyhistorically has accessed diverse funding sources, including short-term andlong-term unsecured bank lines of credit in the United States, Europe, andAsia, as well as the private debt markets in the United States as discussed inNote 7 in the Notes to Consolidated Financial Statements. The Companyexpects to have sufficient sources of liquidity to meet its future fundingneeds due to the multiple funding sources that have been, and continue to be,available to the Company.

The multicurrencyrevolving credit facility, which was a modification of the revolving creditfacility previously outstanding, provides up to $250 million of unsecuredcredit through December 2010. At December 31, 2005 the Company had$98.3 million outstanding under the revolving credit facility. The Companyis required to meet certain financial covenants under this facility asdescribed in Note 7 in the Notes to Consolidated Financial Statements. TheCompany was in compliance with the covenants at December 31, 2005 and isnot aware of any circumstances currently that would impact compliance duringthe next twelve months.

***Cash Flows from Operations***

Cash provided by operations was $116.3 million in2005, approaching the record $124.8 million of cash from operations in 2004. TheCompany invested an additional $24.3 million, excluding the effect of currency,in inventories in 2005 in order to meet the anticipated increase in demand forproduct in early 2006. The inventory increase was offset by an increase inaccrued liabilities of $17.6 million, primarily due to increased tax accrualsin Germany.

Total cash of the Companyincreased $2.9 million from December 31, 2004 to December 31, 2005. AtDecember 31, 2005, cash balances in China totaled $10.5 million, or $4.6million higher than the cash 

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balancesat December 31, 2004. Due to the nature of the governmental and otherregulatory controls, it is difficult to move cash out of China for reasonsother than payment for goods shipped into them. As the Company continues toconsider expanding its manufacturing capabilities in low cost regions, it willmake every effort to utilize the cash balances to fund future expansions. Totalcash outside of China actually decreased by $1.7 million in 2005, which is inline with the Company’s overall goal to minimize the cash on its balance sheetin order to reduce bank borrowings.

***Cash Used in Investing Activities***

As discussed in thebusiness segment results, demand for certain Work Function production hasexceeded capacity in 2005, resulting in investments to increase productioncapacity for future years. Capital expenditures for 2005 totaled $95.2 million.In 2004 $13.2 million of the reported $79.3 million of capital expendituresrelated to the development of the company-wide business system.

***Cash Used in Financing Activities***

The Company continues topay dividends to stockholders on a quarterly basis with $21.8 million of cash usedto pay dividends in 2005. In addition, the Company periodically makesdistributions to its minority interest partners from its various joint ventureactivities with distributions totaling $6.6 million in 2005. The distributionscan vary from year to year depending on the amount of undistributed earnings ofthe businesses and the needs of the partners. The Company borrowed anadditional $9.2 million in 2005, and paid $0.9 million of fees related to themodification of its multicurrency revolving credit facility discussed above.

***Contractual Cash 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 31,2005:

| **Contractual Cash Obligations (3)**           | ** ** | ** ** | ** ** | **Total** | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|---------------------------------------------------------------|------------|------------|------------|-----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|
| Long-term debt                                                |       | $          | 304,000    |      | $          | 168,548  |       | $        | 12,899     |     | $          | 14,205   |       | $        | 13,128     |           | $          | 14,662 |   | $ | 80,558 |   |
| Interest on  long-term debt (1),(2)                      |       | 65,040     |       | 13,055    |       | 11,726   |       | 11,007   |       | 9,945    |       | 8,739    |       | 10,568   |       |
| Capital leases                                                |       | 19,008     |       | 1,666     |       | 988      |       | 988      |       | 988      |       | 988      |       | 13,390   |       |
| Operating leases                                              |       | 54,463     |       | 11,650    |       | 7,402    |       | 4,120    |       | 3,090    |       | 2,874    |       | 25,327   |       |
| Rental and  service agreements with related party Danfoss A/S |       | 58,792     |       | 6,500     |       | 6,364    |       | 6,275    |       | 6,261    |       | 6,261    |       | 27,131   |       |
| Total contractual cash  obligations                           |       | $501,303   |       | $201,419  |       | $39,379  |       | $36,595  |       | $33,412  |       | $33,524  |       | $156,974 |       |
|                                                               |            |            |            |           |            |          |            |          |            |          |            |          |            |          |            |                |            |  |  |  |  |  |  |  |

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The following assumptions are used in the calculationof the contractual cash obligations:

(1)         The annual amountborrowed under revolving credit agreements does not change from the$98.3 million borrowed at December 31, 2005, through the maturitydate of the agreements.

(2)         The margin rate onvariable interest rate debt does not change from December 31, 2005. Thebase interest rate for future years is based on the interest yield curves as ofDecember 31, 2005.

(3)         Commitments denominatedin a currency other than the U.S. dollar are translated at the December 31,2005 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. In 2006the Company anticipates 

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contributing$8.1 million to its U.S. and U.K. pension and health benefit plans. Thereare no plans to fund the German pension plan, which is customary in that country.

**Other Matters**

***Critical Accounting 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 could 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 discussion below should be read in conjunctionwith disclosures elsewhere in this discussion and in the Notes to theConsolidated Financial Statements related to estimates, uncertainties,contingencies, and new accounting standards. Significant accounting policiesare discussed in Note 1 to the Consolidated Financial Statements beginningon page F-5. The development and selection of accounting estimates,including those deemed “critical,” and the associated disclosures in thisdiscussion, have been discussed by management with the audit committee of theBoard of Directors.

*InventoryValuation —*As a manufacturer in the capitalgoods industry, inventory is a substantial portion of the assets of theCompany, amounting to almost 21 percent of total assets at December 31,2005. The Company must periodically evaluate the carrying value of itsinventory to assess the proper valuation. This includes recording periodadjustments as needed to 1) cover losses in the normal course ofoperation, 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 write-downs to cover eachof these items. In doing so, management applies consistent practices based uponhistorical 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.

*WarrantyProvisions —*The Company warrants its variousproducts over differing periods depending upon the type of product andapplication. Consequently, the Company records liabilities for the estimatedwarranty costs that may be incurred under its basic warranty based on pasttrends of actual warranty claims compared to the actual sales levels to whichthose claims apply. These liabilities are accrued at the time the sales of theproducts are recorded. Factors that affect the Company’s warranty liabilityinclude the number of units in the field currently under warranty, historicaland anticipated rates of warranty claims on those units and the cost per claimto satisfy 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.

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In addition to its normal warranty liability, theCompany, from time to time in the normal course of business, incurs costs torepair or replace defective products with a specific customer or group ofcustomers. The Company refers to these as “field recalls” and in theseinstances, the Company will record a specific provision for the expected costsit will incur to repair or replace these products utilizing information fromcustomers and internal information regarding the specific cost of materials andlabor. Typically, field recalls are infrequent in occurrence, however, whenthey occur, field recalls can be for a large number of units and quite costlyto rectify. Because of the sporadic and infrequent nature of field recalls, anddue to the extreme range of costs associated with field recalls, the Companycannot accurately estimate these costs at the time the products are sold.Therefore, these costs are recorded at the time information becomes known tothe Company. As the field recalls are settled, the Company relieves thespecific liability related to that field recall. These specific field recallliabilities are reviewed on a quarterly basis.

*Long-LivedAsset Recovery —*A significant portion of theCompany’s total assets consist of property, plant and equipment (PP&E) anddefinite life intangibles, as well as goodwill. Changes in technology or in theCompany’s intended use of these assets, as well as changes in the broad globaleconomy in which the Company operates, may cause the estimated period of use orthe carrying value of these assets to change.

This requires the Company to periodically assess theestimated useful lives of its assets in order to match, through depreciationand amortization, the cost of those assets with the benefits derived over theperiod of usefulness. The useful lives of these assets can be shortened throughgreater use due to volume increases, rapidly changing technology such as theuse of electronics and computer-operated controls, and through inadequatemaintenance. Despite management’s best efforts to determine the appropriateuseful lives of its equipment, certain situations may arise that lead to anasset or group of assets becoming impaired, meaning their economic valuebecomes less than the value at which the Company is carrying the asset on 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 the periodwhen the impairment becomes known. In addition, goodwill is tested forimpairment at least annually. As of December 31, 2005, a ten percentchange in the depreciable lives of the Company’s assets would impactdepreciation expense by approximately $8.5 million.

*Valuationof Trade Receivables —*The Company records tradereceivables due from its customers at the time a sale is 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 historicalaging of its receivables, looking at the historical losses incurred as apercentage of net sales, and by monitoring the financial strength of itscustomers. In addition, local customary practices have to be taken into accountdue to varying payment terms being applied in various parts of the world wherethe Company conducts its business. If the Company becomes aware of a customer’sinability to meet its financial obligations (e.g., where it has filed forbankruptcy), the Company establishes a specific allowance for the potential baddebt to reduce the net recognized receivable to the amount it reasonablybelieves will be collected. The valuation of trade receivables is performedquarterly.

*WorkersCompensation —*The Company has an insurancepolicy to cover workers compensation claims in the United States, in which theCompany pays 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.

*U.S.Health Care Costs* — The Company self insures itsU.S. health care costs for eligible employees and their qualified dependentswith exposure limited to $0.2 million per individual. The Company 

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establishes reserves for itshealth care cost based on historic claims data and an estimate of incurred, butnot reported claims. This analysis is performed on a quarterly basis.

*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.

The Company’s fundingpolicy for the U.S. plans is to contribute amounts sufficient to meet theminimum funding requirement of the Employee Retirement Income Security Act of1974, plus any additional amounts the Company may deem to be appropriate. In2006 the Company anticipates contributing $5.1 million to its U.S. plansand $1.2 million to its U.K. plans.

*PostretirementBenefits Other Than Pensions —*The Companyprovides postretirement health care benefits for certain employee groups in theUnited States. This plan is contributory and contains certain othercost-sharing features such as deductibles and coinsurance. The Company does notpre-fund this plan and has the right to modify or terminate this plan in thefuture.

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, 2005. As of December 31, 2005, 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 $2.2 million.

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*Deferred Income Taxes —*Tax regulations may require items to be included inthe tax return at different times than the items are reflected in the financialstatements. Some of the differences are permanent, such as expenses that arenot deductible on a tax return, and some of the differences are temporary suchas depreciation expense. Temporary 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 that 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.

***New Accounting Policies***

The Financial Accounting Standards Board (FASB) issuedStatement of Financial Accounting Standard (SFAS) No. 123R, “Share-BasedPayment” in December 2004, which is a revision of SFAS No. 123 “Accountingfor Stock-Based Compensation” and eliminates the alternative of accounting forshare-based compensation using Accounting Principles Board Opinion No. 25,“Accounting for 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 Company adopted SFAS No. 123R in 2005 with no impact on theCompany’s financial position or net income as the Company was previouslyaccounting for stock-based compensation in accordance with SFAS No. 123.

In November 2004 the FASB issued SFAS No. 151,“Inventory Costs.”  SFAS No. 151amends Accounting Research Bulletin No. 43, Chapter 4 on inventory pricingto clarify 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. At December 31, 2005 the impact of adopting this statement would notbe material to the consolidated financial statements.

In December 2004 theFASB issued FASB Staff Position (FSP) No. 109-2 “Accounting andDisclosure Guidance for the Foreign Earnings Repatriation Provision within theJobs Creation Act of 2004” which provides guidance under SFAS No. 109, “Accountingfor Income Taxes,” with respect to recording the potential impact of therepatriation provisions of the American Jobs Creation Act of 2004 (AJCA) on anentity’s income tax expense and tax liability. AJCA was enacted in October,2004 and introduced a limited time 85 percent dividend received deduction onthe repatriation of certain foreign earnings. In 2005 the Company repatriatedapproximately $90.0 million of undistributed earnings from a Danish subsidiaryunder the AJCA and has recorded a related tax expense of $0.8 million.

***Non-Audit Services of Independent Registered PublicAccounting 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 Company anticipates that the U.S.market will continue to grow, but at a more moderate rate than the high growthexperienced in 2005. The European market is expected to grow in 2006 ascompared to the slow market growth experienced in Europe in 2005. The marketsin the 

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Asia-Pacific regionexperienced growth at the end of 2005 and this growth is expected to continueinto 2006. The implementation of the Company’s common business system willcontinue, with the Company’s largest implementation of the North Americanoperations occurring in the second quarter of 2006.

Managementcontinues to strive for a reduction in the overall cost structure and willcontinue to pursue activities to support this goal. A number of actions arebeing considered to accomplish this goal over the next eighteen months,including the phase-out and divesture of underperforming products incombination with the consolidation of select services and facilities. As afirst step in this direction, on March 1, 2006 the Company announced thatit intends to close its LaSalle, Illinois facility. This plant is primarily amachining facility for the Propel segment and the majority of the plantoperations are expected to be outsourced to external suppliers. The Companyanticipates incurring the following range of expenses related to the plantclosure:

| **(in millions)**                  | ** ** | ** ** | ** ** | **Low** | ** ** | **High** | ** ** | ** ** |
|------------------------------------|------------|------------|------------|---------|------------|----------|------------|------------|
| Employee  termination costs        |       | $          | 1.6        |    | $          | 1.8      |       |       |
| Pension  curtailment               |       | 1.5        |       | 1.7     |       |     |
| Property and  equipment impairment |       | 3.9        |       | 5.0     |       |     |
| Other costs                        |       | 1.0        |       | 1.5     |       |     |
| Total costs                        |       | $          | 8.0        |    | $          | 10.0     |       |       |

 

The Company anticipates that approximately 40 to 60percent of the above expenses will result in cash expenditure, including thefunding of a pension plan, which will occur over approximately the next sevento ten years.

Overall, managementanticipates the financial results in 2006 to be favorable compared to 2005.

**Item 7A.   Quantitative and QualitativeDisclosures about Market Risk.**

Certain market risks arediscussed on pages 25-27 of this report, and the other disclosurerequirements are considered either not applicable or not material.

**Item 8.   Financial Statements and SupplementaryData.**

The Consolidated Financial Statements, Report ofManagement, and Reports of Independent Registered Public Accounting Firm arepresented on pages F-1 through F-40 of this report.

**Item 9A.   Controls and Procedures.**

*ConclusionRegarding the Effectiveness of Disclosure Controls and Procedures*

At December 31, 2005 the Registrant carried outan evaluation under the supervision and with the participation of theRegistrant’s management, including the Registrant’s Chief Executive Office andChief Financial Officer, of the effectiveness of the design and operation ofthe Registrant’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14.Based upon that evaluation, the Chief Executive Officer and Chief FinancialOfficer have concluded that the Registrant’s disclosure controls and proceduresare effective to ensure that information required to be disclosed in thereports that the Registrant files or submits under the Exchange Act is recorded,processed, summarized, and reported as required and within the time periodsspecified in the SEC’s rules and forms. There have been no significantchanges in the Registrant’s disclosure controls or in other factors that couldsignificantly affect these controls subsequent to the date of this evaluation.

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*Management’sReport on Internal Control Over Financial Reporting*

The Registrant’smanagement is responsible for establishing and maintaining a system of internalcontrols over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f).This system is augmented by written policies and procedures, careful selectionand training of financial management personnel, a continuing managementcommitment to the integrity of the system, and through examinations by aninternal audit function that coordinates its activities with the Company’sIndependent Registered Public Accounting Firm. There have been no significantchanges in the Registrant’s internal control over financial reporting duringthe fourth quarter with the exception of the implementation of a new businesssystem at one location. This resulted in certain manual processes beingreplaced with automated processing and system integrated accounting postings.

Under the supervision andwith the participation of the Registrant’s management, including the Registrant’sChief Executive Officer and Chief Financial Officer, the Registrant conductedan evaluation of the effectiveness of the Registrant’s internal controls overfinancial reporting based on the framework in Internal Control — IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO). Based on the Registrant’s evaluation under the framework inInternal Control — Integrated Framework, the Registrant’s managementconcluded that our internal control over financial reporting was effective asof December 31, 2005.

The Registrant’smanagement’s assessment of the effectiveness of our internal control overfinancial reporting as of December 31, 2005 has been audited by KPMG LLP,an independent registered public accounting firm, as stated in their reportwhich is presented on pages F-37 and F-38.

 

34

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**PART III**

**Item 10.   Directors and Executive Officers of theRegistrant**

Informationregarding directors of the Company is set forth under the section entitled “ELECTIONOF DIRECTORS” of the Company’s Proxy Statement for the annual meeting ofstockholders to be held June 1, 2006, 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 June 1, 2006, 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 Audit Committee Charter, CompensationCommittee Charter, Executive Committee Charter, and Corporate GovernanceGuidelines are posted on the Company’s website set forth in the preceding paragraph. Also, printed copies of suchcharters and guidelines may be obtained, without charge,by sending a written request to the CorporateSecretary at the address set forth in the preceding paragraph.

**Item11.   Executive Compensation**

Information as to Executive Compensation is set forthunder the section entitled “Executive Compensation” of the Company’s ProxyStatement for the annual meeting of stockholders to be held June 1, 2006,and is incorporated herein by reference.

**Item 12.   Security Ownership of CertainBeneficial Owners and Management**

Information regarding securities authorized forissuance under equity compensation plans is set forth under the sectionentitled “EXECUTIVE COMPENSATION — Equity Compensation” of the Company’s ProxyStatement for the annual meeting of stockholders to be held June 1, 2006,and is incorporated herein by reference. Information regarding securityownership is set forth under the section entitled “SECURITY OWNERSHIP OFCERTAIN BENEFICIAL OWNERS AND MANAGEMENT” of the Company’s Proxy Statement forthe annual meeting of stockholders to be held June 1, 2006, and isincorporated herein by reference.

**Item 13.   Certain Relationships and RelatedTransactions**

In connection with the acquisition of Danfoss FluidPower in May 2000 and the acquisition of additional assets and businessoperations of the fluid power business of Danfoss A/S in January 2001, theCompany has entered into several agreements with Danfoss A/S to purchaseongoing operational services from Danfoss A/S. Information regarding theserelationships and agreements, in addition to other related party transactions,is set forth in Note 14 in the Notes to Consolidated Financial Statementson pages F-29 to F-30 of this report, and is incorporatedherein by reference. Additional information regarding related partytransactions is set forth under the section entitled “GOVERNANCE OF THE COMPANY— Related Transaction” of the Company’s Proxy Statement for the annual meetingof stockholders to be held June 1, 2006, and is incorporated herein byreference.

**Item 14.   Principal Accountant Fees and Services**

Informationregarding accounting 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 June 1,2006, and is incorporated herein by reference.

35

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**PART IV**

**Item 15.**                 Exhibits andFinancial Statement Schedules.

(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 31,2005, 2004, and 2003, on page F-1.

Consolidated Balance Sheets as of December 31,2005 and 2004, on page F-2.

Consolidated Statements of Stockholders’ Equity andComprehensive Income  for the years endedDecember 31, 2005, 2004, and 2003, on page F-3.

Consolidated Statements of Cash Flows for the yearsended December 31, 2005, 2004, and 2003, on page F-4.

Notes to Consolidated Financial Statements, December 31,2005, 2004, and 2003, on pages F-5 through F-33.

Report of Management and Reports of IndependentRegistered Public Accounting Firm, KPMG LLP, on pages F-34 through F-38.

(2)   Thefollowing schedule:

Schedule II, Valuation and Qualifying Accounts,on page F-39.

Report of Independent Registered Public AccountingFirm, KPMG LLP, on Schedule II, on page F-40.

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.                                             |       |

36

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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 as  Exhibit 10.1d to the Companies Form 10-K filed March 14,  2005, and is incorporated herein by reference.                                                                                                                     |   |
| 10.1(e) |   | The  Lease Agreement for the Company’s Swindon, England facility is attached  hereto.                                                                                                                                                                                                                                    |   |
| 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.                                                                                   |   |
| 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.                                                                                   |   |

37

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| 10.1(r)  |   | The Executive  Employment Agreement with Thomas Kittel dated December 1, 2002, 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 December 1, 2002,  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, 2003, 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.                                                                                                                                                |   |
| 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. |   |

38

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| 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  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(ag)  |   | 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(ah)  |   | The  Amendment, effective May 3, 2000, to the Sauer-Danfoss Inc. 1998  Long-Term Incentive Plan referred to in 10.1(ag) 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(ai)  |   | 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(aj)  |   | 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(ak)  |   | 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(ai) 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(al)  |   | 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(am)  |   | 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(an)  |   | 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(ao)  |   | 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 (ap) |   | First Amendment to the Sauer-Danfoss Inc. Annual  Officer Incentive Plan Effective December13, 2005, is attached as exhibit 9.4  to the Company’s Form 8-K filed on December 7, 2005, and is  incorporated herein by reference.                                                                                                         |   |
| 10.1(aq)  |   | 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 (ar) |   | First  Amendment to the Sauer-Danfoss Inc. Deferred Compensation Plan for Selected  Employees, effective December 31, 2005, is attached as exhibit 9.1 to  the Company’s Form 8-K filed on December 7, 2005, and is  incorporated herein by reference.                                                                             |   |

39

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| 10.1(as)  |   | The Sauer-Danfoss  Inc. Supplemental Executive Savings & Retirement Plan (As Amended  and Restated Effective as of January 1, 2005), is attached as exhibit  9.3 to the Company’s 8-K filed on December 7, 2005, and is  incorporated herein by reference.                                                                                                                                                                                                                                                                                                                            |   |
|-----------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|
| 10.1(at)  |   | Summary  of increased non-employee director compensation, effective April 27,  2005, is attached as Exhibit 10.1(bv) to the Company’s Form 8-K  filed on May 3, 2005, and is incorporated herein by reference.                                                                                                                                                                                                                                                                                                                                                                       |   |
| 10.1(au)  |   | Summary  of increase in base salary for the Company’s President and Chief Executive  Officer adopted by the Compensation Committee on February 22, 2005, is  attached as Exhibit 10.1(bw) to the Company’s Form 10-Q filed  on May 10, 2005, and is incorporated herein by reference.                                                                                                                                                                                                                                                                                           |   |
| 10.1(av)  |   | Form of  2005 Performance Unit Award Agreement under the Sauer-Danfoss Inc. 1998  Long-Term Incentive Plan (“LTIP”) representing awards of Performance Units  under the LTIP granted by the Compensation Committee on February 22,  2005 to participants under the LTIP, including all executive officers, as  previously reported on the Form 8-K filed by the Company on  February 28, 2005. The Form of the Award Agreement is attached as  exhibit 10.1(bx) to the Company’s Form 10-Q filed on May 10,  2005, and is incorporated herein by reference. |   |
| 10.1(aw)  |   | Form of  Non-employee Director Restricted Stock Award Agreement, is attached as  Exhibit 10.1(by) to the Company’s Form 10-Q filed on  May 10, 2005, and is incorporated herein by reference, representing the  grant of 1,500 shares of Restricted Stock awarded by the Board of Directors  to each non-employee director on April 27, 2005 pursuant to the  Sauer-Danfoss Inc. Non-employee Director Stock Option and Restricted Stock  Plan, as previously reported in the Company’s Form 8-K filed on  May 3, 2005.                                          |   |
| 10.1 (ax) |   | The  Sauer-Danfoss Inc. 409A Deferred Compensation Plan for Selected Employees,  effective December 13, 2005, is attached as Exhibit 9.2 to the  Company’s Form 8-K, filed on December 7, 2005, and is  incorporate herein by reference                                                                                                                                                                                                                                                                                                                                              |   |
| 10.1 (ay) |   | First  Amendment to the Sauer-Danfoss Inc. 409A Deferred Compensation Plan for  Selected Employees effective January 1, 2006, is attached as  Exhibit 9.5 to the Companies Form 8-K filed on December 7,  2005, and is incorporated herein by reference.                                                                                                                                                                                                                                                                                                                                  |   |
| 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)          The exhibits that arelisted under Item 15(a)(3) above are filed or incorporated by referencehereunder.

40

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**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 10, 2006

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 10, 2006 |
| David J.  Anderson      |          | Executive Officer                   |       |                |
| /s/ KARL J. SCHMIDT          |          | Executive Vice President and Chief  |       | March 10, 2006 |
| Karl J.  Schmidt        |          | Financial Officer                   |       |                |
| /s/ KENNETH D. MCCUSKEY      |          | Vice President and Chief Accounting |       | March 10, 2006 |
| Kenneth D.  McCuskey    |          | Officer,  Secretary                 |       |                |
| /s/ OLE STEEN ANDERSEN       |          | Director                            |       | March 10, 2006 |
| Ole Steen  Andersen          |          |                                |       |                |
| /s/ JØRGEN M. CLAUSEN   |          | Director                            |       | March 10, 2006 |
| JØrgen M.  Clausen |          |                                |       |                |
| /s/ NICOLA KEIM              |          | Director                            |       | March 10, 2006 |
| Nicola Keim                  |          |                                |       |                |
| /s/ JOHANNES F. KIRCHHOFF    |          | Director                            |       | March 10, 2006 |
| Johannes F.  Kirchhoff  |          |                                |       |                |
| /s/ HANS KIRK                |          | Director                            |       | March 10, 2006 |
| Hans Kirk                    |          |                                |       |                |

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| /s/ F. JOSEPH LOUGHREY   |   | Director |   | March 10, 2006 |
|--------------------------|--------|----------|--------|---------------------|
| F. Joseph  Loughrey |   |     |   |                |
| /s/ KLAUSE H. MURMANN    |   | Director |   | March 10, 2006 |
| Klaus H.  Murmann   |   |     |   |                |
| /s/ SVEN MURMANN         |   | Director |   | March 10, 2006 |
| Sven Murmann             |   |     |   |                |
| /s/ STEVEN H. WOOD       |   | Director |   | March 10, 2006 |
| Steven H.  Wood     |   |     |   |                |

 

 

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**Sauer-Danfoss Inc.and Subsidiaries**

**ConsolidatedStatements of Income**

**(Dollarsin thousands, except per share data)**

| ** **                                           | ** ** | **For the Years Ended December 31,** | ** ** |
|------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Net  Sales**                                       |       | $                                                             | 1,547,816  |   | $ | 1,404,159 |   | $ | 1,126,774 |   |
| **Costs and Expenses:**                              |       |                                                          |       |   |   |   |   |
| Cost of sales                                        |       | 1,190,070                                                     |       | 1,058,075 |   | 874,410 |   |
| Selling, general and administrative                  |       | 217,130                                                       |       | 200,142 |   | 156,658 |   |
| Research and development                             |       | 58,673                                                        |       | 51,913 |   | 43,456 |   |
| Loss on disposal of fixed assets                     |       | 1,391                                                         |       | 2,119 |   | 5,328 |   |
| Total costs and expenses                             |       | 1,467,264                                                     |       | 1,312,249 |   | 1,079,852 |   |
| Operating income                                     |       | 80,552                                                        |       | 91,910 |   | 46,922 |   |
| **Nonoperating  Income (Expenses):**                 |       |                                                          |       |   |   |   |   |
| Interest expense                                     |       | (17,540                                                       | )          | (18,403 | ) | (18,748 | ) |
| Interest income                                      |       | 1,887                                                         |       | 988 |   | 1,348 |   |
| Other, net                                           |       | 3,465                                                         |       | (4,052 | ) | (3,358 | ) |
| Nonoperating expenses, net                           |       | (12,188                                                       | )          | (21,467 | ) | (20,758 | ) |
| **Income Before Income Taxes and Minority Interest** |       | 68,364                                                        |       | 70,443 |   | 26,164 |   |
| **Minority  Interest and Equity Income, net**        |       | (18,657                                                       | )          | (21,522 | ) | (15,405 | ) |
| **Income Before Income Taxes**                       |       | 49,707                                                        |       | 48,921 |   | 10,759 |   |
| **Income  Tax Benefit (Expense)**                    |       | (10,992                                                       | )          | (15,735 | ) | 474 |   |
| **Net Income**                                       |       | $                                                             | 38,715     |   | $ | 33,186 |   | $ | 11,233 |   |
| Net Income per  common share, basic                  |       | $                                                             | 0.82       |   | $ | 0.70 |   | $ | 0.24 |   |
| Net Income per  common share, diluted                |       | $                                                             | 0.81       |   | $ | 0.70 |   | $ | 0.24 |   |
| Weighted average  basic shares outstanding           |       | 47,455,507                                                    |       | 47,409,377 |   | 47,401,223 |   |
| Weighted average diluted  shares outstanding         |       | 47,795,160                                                    |       | 47,509,941 |   | 47,516,093 |   |

 

See accompanying notes to consolidated financial statements.

F-1

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**Sauer-Danfoss Inc. and SubsidiariesConsolidated Balance Sheets(Dollars in thousands, except per share data)**

| ** **                                                                                                                                                |   | **December 31,** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|
| ** **                                                                                                                                                |   | **2005**              | ** ** | **2004** |   |
| **Assets**                                                                                                                                                |   |                  |       |   |   |
| **Current Assets:**                                                                                                                                       |   |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                 |   | $                     | 14,194     |   | $ | 11,273 |   |
| Accounts receivable (net  of allowances fo doubtful accounts of $4,900 and $4,671 in 2005 and 2004,  respectively)                                        |   | 220,752               |       | 233,146 |   |
| Inventories                                                                                                                                               |   | 245,383               |       | 241,562 |   |
| Other current assets                                                                                                                                      |   | 31,891                |       | 40,131 |   |
| Total current  assets                                                                                                                                     |   | 512,220               |       | 526,112 |   |
| **Property, Plant and Equipment,  net**                                                                                                                   |   | 450,426               |       | 478,543 |   |
| **Other Assets:**                                                                                                                                         |   |                  |       |   |   |
| Goodwill                                                                                                                                                  |   | 120,318               |       | 129,554 |   |
| Other intangible assets,  net                                                                                                                             |   | 29,587                |       | 33,357 |   |
| Deferred income taxes                                                                                                                                     |   | 42,871                |       | 32,990 |   |
| Other                                                                                                                                                     |   | 15,491                |       | 11,025 |   |
| Total other assets                                                                                                                                        |   | 208,267               |       | 206,926 |   |
|                                                                                                                                                      |   | $                     | 1,170,913  |   | $ | 1,211,581 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                             |   |                  |       |   |   |
| **Current Liabilities:**                                                                                                                                  |   |                  |       |   |   |
| Notes payable and bank  overdrafts                                                                                                                        |   | $                     | 28,275     |   | $ | 23,609 |   |
| Long-term debt due within  one year                                                                                                                       |   | 168,548               |       | 244,987 |   |
| Accounts payable                                                                                                                                          |   | 107,090               |       | 130,071 |   |
| Accrued salaries and  wages                                                                                                                               |   | 44,035                |       | 46,988 |   |
| Accrued warranty                                                                                                                                          |   | 17,047                |       | 16,392 |   |
| Other accrued liabilities                                                                                                                                 |   | 46,312                |       | 35,940 |   |
| Total current  liabilities                                                                                                                                |   | 411,307               |       | 497,987 |   |
| **Long-Term Debt**                                                                                                                                        |   | 135,452               |       | 76,496 |   |
| **Other Liabilities**                                                                                                                                     |   |                  |       |   |   |
| Long-term pension  liability                                                                                                                              |   | 49,590                |       | 57,148 |   |
| Postretirement benefits  other than pensions                                                                                                              |   | 19,461                |       | 18,545 |   |
| Deferred income taxes                                                                                                                                     |   | 44,277                |       | 48,454 |   |
| Other                                                                                                                                                     |   | 20,464                |       | 28,949 |   |
| Total other  liabilities                                                                                                                                  |   | 133,792               |       | 153,096 |   |
| **Minority Interest in Net Assets  of Consolidated Companies**                                                                                            |   | 51,440                |       | 39,927 |   |
| **Stockholders’ Equity:**                                                                                                                            |   |                  |       |   |   |
| Preferred stock, par  value $.01 per share, authorized 4,500,000 shares, no shares issued or  outstanding                                                 |   | —                |       | — |   |
| Common stock, par value  $.01 per share, authorized shares 75,000,000 in 2005 and 2004; issued and  outstanding 47,498,232 in 2005 and 47,445,768 in 2004 |   | 475                   |       | 474 |   |
| Additional paid-in  capital                                                                                                                               |   | 332,861               |       | 319,871 |   |
| Retained earnings                                                                                                                                         |   | 78,176                |       | 62,257 |   |
| Accumulated other  comprehensive income                                                                                                                   |   | 27,410                |       | 61,710 |   |
| Unamortized restricted  stock compensation                                                                                                                |   | —                |       | (237 | ) |
| Total  stockholders’ equity                                                                                                                          |   | 438,922               |       | 444,075 |   |
|                                                                                                                                                      |   | $                     | 1,170,913  |   | $ | 1,211,581 |   |

 

See accompanying notes to consolidated financialstatements.

F-2

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**Sauer-Danfoss Inc. and SubsidiariesConsolidated Statements of Stockholders’ Equity and Comprehensive Income(Dollars in thousands, except per share data)**
|                                                                | ** ** | **Number of  Shares  Outstanding** | ** ** | **Common  Stock** | ** ** | **Aditional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** | **Unamortized  Restricted  Stock  Compensation** | ** ** | **Total** | ** ** |
|----------------------------------------------------------------|------------|-----------------------------------------|------------|-------------------|------------|---------------------------------|------------|------------------------|------------|-----------------------------------------------|------------|--------------------------------------------------|------------|-----------|------------|
| **Year Ended December 31,  2003**                         |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Beginning balance                                              |       |                                    | 47,418,768 |              |       |                            | $          | 474                    |       |                                          |       | $                                                | 313,760    |      |       |   | $ | 47,870 |   |   |   | $ | 5,346 |   |   |   | $ | (119 | ) |   | $ | 367,331 |   |
| Comprehensive income:                                          |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 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                                         |       |                                    | 13,500     |              |       |                            | —     |                   |       |                                          | 136        |                                             |       |      | —     |   |   |   | — |   |   |   | (136 | ) |   | — |   |
| Restricted stock compensation                                  |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | —     |   |   |   | — |   |   |   | 98 |   |   | 98 |   |
| Deemed dividend                                                |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | (621       | ) |   |   | — |   |   |   | — |   |   | (621 | ) |
| Cash dividends declared ($.28 per share)                  |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | (13,280    | ) |   |   | — |   |   |   | — |   |   | (13,280 | ) |
| Ending Balance                                                 |       |                                    | 47,432,268 |              |       |                            | 474        |                   |       |                                          | 314,319    |                                             |       |      | 45,202     |   |   |   | 37,376 |   |   |   | (157 | ) |   | 397,214 |   |
| **Year  Ended December 31, 2004:**                        |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Comprehensive income:                                          |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| 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                                         |       |                                    | 13,500     |              |       |                            | —     |                   |       |                                          | 208        |                                             |       |      | —     |   |   |   | — |   |   |   | (208 | ) |   | — |   |
| Restricted stock compensation                                  |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | —     |   |   |   | — |   |   |   | 128 |   |   | 128 |   |
| Cash dividends declared ($.34 per share)                  |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | (16,131    | ) |   |   | — |   |   |   | — |   |   | (16,131 | ) |
| Ending Balance                                                 |       |                                    | 47,445,768 |              |       |                            | 474        |                   |       |                                          | 319,871    |                                             |       |      | 62,257     |   |   |   | 61,710 |   |   |   | (237 | ) |   | 444,075 |   |
| **Year  Ended December 31, 2005:**                        |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Comprehensive income:                                          |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                                     |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | 38,715     |   |   |   | — |   |   |   | — |   |   | — |   |
| Pension adjustment                                             |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | —     |   |   |   | 92 |   |   |   | — |   |   | — |   |
| Unrealized losses on hedging activities                        |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | —     |   |   |   | 192 |   |   |   | — |   |   | — |   |
| Currency Translation                                           |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | —     |   |   |   | (34,584 | ) |   |   | — |   |   | — |   |
| Total comprehensive income                                     |       |                                    |       |              |       |                            |       |                   |       |                                          |       |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   | 4,415 |   |
| Adoption of SFAS No. 123R “Share Based Payment” |       |                                    | —     |              |       |                            | —     |                   |       |                                          | (237       | )                                                |       |      | —     |   |   |   | — |   |   |   | 237 |   |   | — |   |
| Performance units vested                                       |       |                                    | 38,964     |              |       |                            | 1          |                   |       |                                          | (1         | )                                                |       |      | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Modification of performance units                              |       |                                    |       |              |       |                            |       |                   |       |                                          | 3,545      |                                             |       |      |       |   |   |   |   |   |   |   |   |   |   | 3,545 |   |
| Restricted stock grant                                         |       |                                    | 13,500     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Restricted stock and performance unit compensation             |       |                                    |       |              |       |                            |       |                   |       |                                          | 9,683      |                                             |       |      |       |   |   |   |   |   |   |   | — |   |   | 9,683 |   |
| Cash dividends declared ($.48 per share)                       |       |                                    | —     |              |       |                            | —     |                   |       |                                          | —     |                                             |       |      | (22,796    | ) |   |   | — |   |   |   | — |   |   | (22,796 | ) |
| Ending Balance                                                 |       |                                    | 47,498,232 |              |       |                            | $          | 475                    |       |                                          |       | $                                                | 332,861    |      |       |   | $ | 78,176 |   |   |   | $ | 27,410 |   |   |   | $ | — |   |   | $ | 438,922 |   |
|                                                                |            |                                         |            |                   |            |                                 |            |                        |            |                                               |            |                                                  |            |           |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

See accompanying notes to consolidated financialstatements.

F-3

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**Sauer-Danfoss Inc.and SubsidiariesConsolidated Statements of Cash Flows(Dollars in thousands)**
|                                                                                              | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2005**                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| **Cash Flows from Operating  Activities:**                                                   |       |                                                          |       |   |   |   |   |
| Net Income                                                                                   |       | $                                                             | 38,715     |   | $ | 33,186 |   | $ | 11,233 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities: |       |                                                          |       |   |   |   |   |
| Depreciation and amortization                                                                |       | 88,322                                                        |       | 82,363 |   | 80,377 |   |
| Minority interest and equity income, net                                                     |       | 18,657                                                        |       | 21,522 |   | 15,405 |   |
| Restricted stock and performance unit compensation                                           |       | 9,683                                                         |       | 5,344 |   | — |   |
| (Increase)  decrease in working capital, excluding effects of acquisitions —       |       |                                                          |       |   |   |   |   |
| Accounts receivable, net                                                                     |       | (4,829                                                        | )          | (30,780 | ) | (5,542 | ) |
| Inventories                                                                                  |       | (24,276                                                       | )          | (24,287 | ) | (7,616 | ) |
| Accounts payable                                                                             |       | (13,368                                                       | )          | 22,705 |   | 6,121 |   |
| Accrued liabilities                                                                          |       | 17,621                                                        |       | 10,191 |   | 6,188 |   |
| Change in deferred income taxes                                                              |       | (12,449                                                       | )          | (2,174 | ) | (12,371 | ) |
| Other                                                                                        |       | (1,764                                                        | )          | 6,742 |   | 1,763 |   |
| Net cash provided by operating activities                                                    |       | 116,312                                                       |       | 124,812 |   | 95,558 |   |
| **Cash  Flows from Investing Activities:**                                                   |       |                                                          |       |   |   |   |   |
| Purchases of property, plant and equipment                                                   |       | (95,247                                                       | )          | (79,257 | ) | (59,991 | ) |
| Payments for acquisitions and license rights, net of  cash acquired                          |       | —                                                        |       | (5,656 | ) | (7,202 | ) |
| Proceeds from sales of property, plant and equipment                                         |       | 1,942                                                         |       | 9,367 |   | 2,204 |   |
| Net cash used in investing activities                                                        |       | (93,305                                                       | )          | (75,546 | ) | (64,989 | ) |
| **Cash  Flows from Financing Activities:**                                                   |       |                                                          |       |   |   |   |   |
| Net borrowings (repayments) on  notes payable and bank overdrafts                            |       | 7,598                                                         |       | (14,978 | ) | 1,120 |   |
| Net borrowings (repayments) on revolving credit  facility                                    |       | (62,355                                                       | )          | 33,420 |   | 33,018 |   |
| Repayments of long-term debt                                                                 |       | (13,253                                                       | )          | (42,355 | ) | (34,200 | ) |
| Borrowings of long-term debt                                                                 |       | 77,190                                                        |       | — |   | — |   |
| Payments for debt financing costs                                                            |       | (898                                                          | )          | — |   | (1,824 | ) |
| Cash dividends                                                                               |       | (21,843                                                       | )          | (14,706 | ) | (13,280 | ) |
| Distribution to minority interest partners                                                   |       | (6,570                                                        | )          | (14,711 | ) | (13,667 | ) |
| Net cash used in financing activities                                                        |       | (20,131                                                       | )          | (53,330 | ) | (28,833 | ) |
| **Effect of Exchange Rate Changes on Cash**                                                  |       | 45                                                            |       | 251 |   | 953 |   |
| **Cash  and Cash Equivalents:**                                                              |       |                                                          |       |   |   |   |   |
| Net increase (decrease) during the year                                                      |       | 2,921                                                         |       | (3,813 | ) | 2,689 |   |
| Beginning balance                                                                            |       | 11,273                                                        |       | 15,086 |   | 12,397 |   |
| Ending balance                                                                               |       | $                                                             | 14,194     |   | $ | 11,273 |   | $ | 15,086 |   |
| **Supplemental  Cash Flow Disclosures:**                                                     |       |                                                          |       |   |   |   |   |
| Interest paid                                                                                |       | $                                                             | 15,601     |   | $ | 17,984 |   | $ | 18,581 |   |
| Income taxes paid                                                                            |       | $                                                             | 14,780     |   | $ | 12,324 |   | $ | 12,825 |   |
|                                                                                              |            |                                                               |            |  |  |  |  |  |  |  |  |  |  |

 

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, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summary of SignificantAccounting 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,material handling, and specialty vehicle equipment. The Company’s products aresold throughout the world 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 of Estimates —*

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.

*Revenue Recognition —*

Net sales are recorded whenall of the following criteria are met: persuasive evidence of an arrangementexists, delivery has occurred, the price is fixed and determinable, andcollectibility is reasonably assured. Estimates for future warranty expense arerecorded when the related revenue is recognized. Timing of revenue recognition isconsistent with when the risks and rewards of ownership and title to theproduct have transferred to the customer.

*Cash and CashEquivalents —*

Cash equivalents areconsidered by the Company to be all highly liquid instruments purchased withoriginal maturities of three months or less. At December 31, 2005 cashbalances in China totaled approximately $10,500 and due to the nature of thegovernmental and other regulatory controls it is difficult to move cash out ofthis country for reasons other than payment for goods shipped into them.

*Trade Receivables —*

The Company records trade receivables due from itscustomers at the time sales are recorded in accordance with its revenuerecognition policy. The future collectibility of these amounts can be impacted bythe Company’s collection efforts, the financial stability of its customers, andthe general economic climate in which it operates. The Company applies aconsistent practice of establishing an allowance for accounts that it believesmay become uncollectible through reviewing the historical aging of itsreceivables and by monitoring the financial strength of its customers. If theCompany becomes aware of a customer’s inability to meet its financialobligations (e.g., where it has filed for bankruptcy), the Company establishes 

F-5

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summaryof Significant Accounting Policies: (Continued)**

aspecific 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.

*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 was18%, 45%, and 37%, respectively, for 2005 and 17%, 42%, and 41%, respectively,for 2004.

*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 ($38,697,$36,533, and $27,208 in 2005, 2004, and 2003, 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.

*Product Warranty —*

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 

F-6

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summaryof Significant Accounting Policies: (Continued)**

claim to satisfy theCompany’s warranty obligation. The anticipated rate of warranty claims is theprimary factor impacting the Company’s estimated warranty obligation. Eachquarter, the Company reevaluates its estimates to assess the adequacy of itsrecorded warranty liabilities and adjusts the amounts as necessary.

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.

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

Consistent with therequirements of Statement of Financial Accounting Standards (SFAS) No. 144,“Accounting for the Impairment or Disposal of Long-Lived Assets,” the Companyperiodically assesses whether events or circumstances have occurred that mayindicate the carrying value of its long-lived tangible and intangible assetsmay not be recoverable. The carrying value of long-lived tangible andintangible assets to be held and used is evaluated based on the expected futureundiscounted operating cash flows. When events or circumstances indicate thecarrying value of an asset or group of assets is impaired, the Companyrecognizes an impairment loss to the extent that the carrying value of theassets exceeds the fair value of the assets.

*Income Taxes —*

The provision for incometaxes has been determined using the asset and liability approach of accountingfor income taxes. Under this approach, deferred taxes represent the future taxconsequences expected to occur when the reported amounts of assets andliabilities are recovered or paid. The provision for income taxes representsincome taxes paid or payable for the current year plus the change in deferredtaxes during the year. Deferred taxes result from differences between thefinancial and tax bases of the Company’s assets and liabilities, net operatingloss carryforwards, and tax credit carryforwards and are adjusted for changesin tax rates and tax laws when changes are enacted. Valuation allowances arerecorded to reduce deferred tax assets when it is more likely than not that atax benefit will not be realized.

*Income Per Share —*

Basic net income per common share is based on theweighted average number of common shares outstanding in each year. Diluted netincome per common share assumes that outstanding common shares were increasedby shares issuable upon (i) exercise of restricted stock shares, and (ii) grantingof shares under the long-term incentive plan, after it becomes certain that theperformance requirements needed to 

F-7

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summaryof Significant Accounting Policies: (Continued)**

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.

| ** **                      | ** ** | **Net Income** | ** ** | **Shares** | ** ** | **EPS** | ** ** |
|---------------------------------|------------|---------------------|------------|------------|------------|---------|------------|
| December 31,  2005         |       |                |       |       |       |    |       |   |   |
| Basic net income                |       |                | $          | 38,715     |       |    | 47,455,507 |   | $ | 0.82 |   |
| Effect of dilutive  securities: |       |                |       |       |       |    |       |   |   |
| Restricted stock                |       |                | —     |       |       | 22,486  |       | — |   |
| Performance units               |       |                | —     |       |       | 317,167 |       | (0.01 | ) |
| Diluted net  income             |       |                | $          | 38,715     |       |    | 47,795,160 |   | $ | 0.81 |   |
| December 31,  2004         |       |                |       |       |       |    |       |   |   |
| Basic net income                |       |                | $          | 33,186     |       |    | 47,409,377 |   | $ | 0.70 |   |
| Effect of dilutive  securities: |       |                |       |       |       |    |       |   |   |
| Restricted stock                |       |                | —     |       |       | 18,185  |       | — |   |
| Performance units               |       |                | —     |       |       | 82,379  |       | — |   |
| Diluted net  income             |       |                | $          | 33,186     |       |    | 47,509,941 |   | $ | 0.70 |   |
| December 31,  2003         |       |                |       |       |       |    |       |   |   |
| Basic net income                |       |                | $          | 11,233     |       |    | 47,401,223 |   | $ | 0.24 |   |
| Effect of dilutive  securities: |       |                |       |       |       |    |       |   |   |
| Restricted stock                |       |                | —     |       |       | 12,885  |       | — |   |
| Performance units               |       |                | —     |       |       | 101,985 |       | — |   |
| Diluted net income              |       |                | $          | 11,233     |       |    | 47,516,093 |   | $ | 0.24 |   |

 

*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 these instruments.

The fair value of long-term debt is calculated bydiscounting scheduled cash flows through maturity using estimated marketdiscount rates. The discount rate is estimated using the rates currentlyoffered for long-term debt of similar remaining maturities. At December 31,2005 the Company estimated the fair value of its long-term debt, includingamounts due within one year, at $307,550 compared to its carrying value of$304,000. The estimated fair value of long-term debt at December 31, 2004was $307,547 compared to its carrying value of $321,483. These estimates aresubjective in nature and involve uncertainties and matters of significantjudgment and, therefore, cannot be determined with precision. Changes inassumptions could significantly affect these estimates.

F-8

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summaryof Significant Accounting Policies: (Continued)**

*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, 2005 and 2004, the Company had threeinterest rate swaps outstanding that mature at various dates through March 2009.The combined notional amount of the three contracts is 6,769 euros at December 31,2005. There is no ineffectiveness of the interest rate swaps and therefore, thechanges in fair value of the derivatives is recorded in accumulated othercomprehensive income.

In 2005 the Company began to enter into forwardcontracts to minimize the impact of currency fluctuations on cash flows relatedto forecasted sales denominated in currencies other than the functionalcurrency of the selling location. The forward contracts qualify for hedgeaccounting and therefore are subject to effectiveness testing at the inceptionof the contract and throughout the life of the contract. The fair value offorward contracts outstanding at December 31, 2005 of $17 was recorded asa liability on the consolidated balance sheet.

At December 31, 2004the Company was party to a foreign currency contract, which matured in January 2005,to protect against the effects of foreign currency fluctuations for a loan tothe U.S. holding company from a Danish bank denominated in 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 theconsolidated balance sheets adjusted to fair value.

*EmployeeStock-Based Compensation —*

The Company accounts foremployee stock-based compensation in accordance with SFAS No. 123R, “Share-BasedPayments.” The fair value method to account for employee-stock compensation wasadopted in 2003.

F-9

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summaryof Significant Accounting Policies: (Continued)**

*New AccountingPrinciples —*

In December 2004 the Financial AccountingStandards Board (FASB) issued FASB Staff Position (FSP) No. 109-2 “Accountingand Disclosure Guidance for the Foreign Earnings Repatriation Provision withinthe Jobs Creation Act of 2004” which provides guidance under SFAS No. 109,“Accounting for Income Taxes,” with respect to recording the potential impactof the repatriation provisions of the American Jobs Creation Act of 2004 (AJCA)on an entity’s income tax expense and tax liability. AJCA was enacted in October,2004 and introduced a limited time 85% dividend received deduction on therepatriation of certain foreign earnings. FSP No. 109-2 states thatan entity is allowed time beyond the financial reporting period of enactment toevaluate the effect of the AJCA on its plan for reinvestment or repatriation offoreign earnings for purposes of applying SFAS No. 109. In 2005 theCompany repatriated approximately $90,000 of undistributed earnings from aDanish subsidiary under the AJCA and has recorded a related tax expense of$829.

The FASB issued FASB Interpretation No. (FIN) 47,“Accounting for Conditional Asset Retirement Obligations” in March 2005,which clarifies the term “conditional asset retirement obligation” used in SFASNo. 143, “Accounting for Asset Retirement Obligations.” The Companyadopted the requirements of FIN 47 in 2005 with no effect on the Company’sconsolidated financial statements.

The FASB issued SFAS No. 123R, “Share-BasedPayment” in December 2004, which is a revision of SFAS No. 123 “Accountingfor Stock-Based Compensation” and eliminates the alternative of accounting forshare-based compensation using Accounting Principles Board Opinion No. 25,“Accounting for 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 Company adopted SFAS No. 123R in 2005 with no impact on theCompany’s financial position or net income as the Company adopted SFAS No. 148,“Accounting for Stock-Based Compensation — Transition and Disclosure” in2003. In accordance with SFAS No. 148, the Company selected theprospective method of reporting this change in accounting principle, whichallowed the Company to apply the recognition provisions to all employee awardsgranted, modified or settled after January 1, 2003.

In May 2004 the Financial Accounting StandardsBoard (FASB) issued Staff Position (FSP) 106-2, “Accounting andDisclosure Requirements Related to the Medicare Prescription Drug Improvementand Modernization 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’s retiree health and accident plan is at least actuariallyequivalent to Medicare Part D and is eligible for the federal subsidy. TheCompany determined that the impact of the Act on the financial statements wasnot material and therefore was not considered a significant event. The effectsof the Act were incorporated in the measurement of plan assets and obligationthat was completed as of December 31, 2005 resulting in a decrease of$1,465 in the amount of unrecognized actuarial loss. The 

F-10

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(1) Summaryof Significant Accounting Policies: (Continued)**

effects of the Act arebeing amortized over the expected remaining life of the Plan participants,resulting in a reduction to the annual postretirement benefit expense of approximately$200.

The FASB issued FIN No. 46R, “Consolidation ofVariable 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. 132R, “Employers’Disclosures about Pensions and Other Postretirement Benefits — anamendment of FASB Statements No. 87, 88, and 106” in 2003, with additionaldisclosures 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. There was no impact on the consolidated financialstatements other than the additional disclosure in Note 10.

In November 2004 theFASB issued SFAS No. 151, “Inventory Costs.”  SFAS No. 151 amends Accounting ResearchBulletin No. 43, Chapter 4 on inventory pricing to clarify that abnormalamounts of idle facility expense, freight, handling costs, and wasted materialsshould be recognized as current period charges. In addition, SFAS No. 151requires that allocation of fixed production overhead to the costs ofconversion be based on the normal capacity of the production facilities. TheCompany is required to adopt SFAS No. 151 in 2006. At December 31,2005 the impact of adopting this statement would not be material to theconsolidated financial statements.

*Reclassifications —*

Certain previously reported amounts have beenreclassified to conform to the current period presentation.

F-11

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(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.

Thechanges in the carrying amount of goodwill for the years ended December 31,2004 and 2005 are as follows:

| ** **                                | ** ** | **Propel  Segment** | ** ** | **Work  Function  Segment** | ** ** | **Controls  Segment** | ** ** | **Total** | ** ** |
|-------------------------------------------|------------|---------------------|------------|-----------------------------|------------|-----------------------|------------|-----------|------------|
| Balance at  January 1, 2004          |       | $                   | 34,169     |                        | $          | 20,398                |       | $         | 65,087     |   | $ | 119,654 |   |
| Goodwill acquired  during period          |       | —              |       | —                      |       | 4,009                 |       | 4,009     |       |
| Reclassify  goodwill to intangible assets |       | —              |       | —                      |       | 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 |   |
| Translation  adjustment                   |       | (2,531              | )          | (1,511                      | )          | (5,194                | )          | (9,236    | )          |
| Balance as of  December 31, 2005     |       | $                   | 32,967     |                        | $          | 19,680                |       | $         | 67,671     |   | $ | 120,318 |   |

 

F-12

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars 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. No significant restructuring projects were underway in 2005. The costsrelated to the Sturtevant and West Branch restructurings were included in theWork Function segment. The charges related to the European sales anddistribution restructuring were allocated to all segments. The following tablesummarizes the restructuring charges incurred in 2004 and 2003:

| ** **                                             | ** ** | **Work Function  Segment** | ** ** | **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 was completedin December 2004.

**(4) Inventories:**

Thecomposition of inventories is as follows:

| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Raw materials             |       | $                     | 101,912    |   | $ | 93,275 |   |
| Work in progress          |       | 59,583                |       | 57,561 |   |
| Finished goods  and parts |       | 98,530                |       | 102,115 |   |
| LIFO allowance            |       | (14,642               | )          | (11,389 | ) |
| Total                     |       | $                     | 245,383    |   | $ | 241,562 |   |

 

F-13

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars 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,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Cost —                          | ** ** | ** **            | ** ** | ** ** | ** ** |
| Land and improvements                     |       | $                     | 15,134     |   | $ | 14,346 |   |
| Buildings and improvements                |       | 117,901               |       | 109,845 |   |
| Machinery and equipment                   |       | 981,647               |       | 1,006,162 |   |
| Construction in progress                  |       | 42,778                |       | 52,502 |   |
| Plant and  equipment under capital leases |       | 15,447                |       | 17,888 |   |
| Total costs                               |       | 1,172,907             |       | 1,200,743 |   |
| Less — accumulated depreciation |       | (722,481              | )          | (722,200 | ) |
| Net property, plant and  equipment        |       | $                     | 450,426    |   | $ | 478,543 |   |

 

Depreciation expense for 2005, 2004, and 2003 was$85,346, $79,307, and $77,584, 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 sheet at December 31, 2003 andincluded in Global Services for segment reporting. In 2004 this property wassold 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 animpairment charge of approximately $1,500, which was included in loss ondisposal of fixed assets on the consolidated statements of income. The Companyalso has an undeveloped piece of land in Brooklyn Park, Minnesota, which has acarrying value of approximately $3,000. These two properties are classified asother current assets on the consolidated balance sheets at December 31,2005 and 2004 as they are held for sale. These properties are included in WorkFunction and Global Services, respectively, for segment reporting. Based uponits most recent analysis, the Company believes that no further impairmentsexisted at December 31, 2005.

F-14

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(6) IntangibleAssets:**

Thefollowing table summarizes the components of the other intangible assetbalances at December 31, 2005 and 2004:

| ** **                    | ** ** | **Trade  Name** | ** ** | **Technology** | ** ** | **Customer  Relationships** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-------------------------------|------------|-----------------|------------|----------------|------------|-----------------------------|------------|-----------|------------|-----------|------------|
| *December 31, 2005*      |       |            |       |           |       |                        |       |      |       |      |       |   |   |   |   |
| Cost                          |       | $               | 19,000     |           |       | $                           | 11,263     |      |       |      | $          | 6,065 |   |   | $ | 5,057 |   | $ | 41,385 |   |
| Accumulated  amortization     |       | (2,715          | )          |           | (3,965     | )                           |       |      | (2,242     | )         |       | (2,876 | ) | (11,798 | ) |
| Other intangible  assets, net |       | $               | 16,285     |           |       | $                           | 7,298      |      |       |      | $          | 3,823 |   |   | $ | 2,181 |   | $ | 29,587 |   |
| *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 |   |

 

The change in the cost ofintangible assets presented is due to the difference in the currency exchangerates at December 31, 2005 and 2004. Amortization of intangible assets was$2,976, $3,056, and $2,793 in 2005, 2004, and 2003, respectively. Amortizationexpense is expected to be approximately $2,100, $1,700, $1,600, $1,500, and$1,500 in 2006 through 2010.

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

Long-termdebt outstanding at December 31, 2005 and 2004 consisted of the following:

| ** **                                                    | ** ** | **2005**                                                            | ** ** | **2004**                  | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------------------------------------|------------|---------------------------|------------|
| ** **                                                    | ** ** | **Long-term   debt due  within  one year** | ** ** | **Long-term   debt** | ** ** | **Long-term   debt due  within one year** | ** ** | **Long-term   debt** | ** ** |
| Multicurrency  Revolving Facility                             |       |                                                                | $          | 98,268                    |       |   |   | $ | — |   |   |   | $ | 123,528 |   |   |   | $ | — |   |   |
| Danish Revolving  Credit Facility                             |       |                                                                | 56,278     |                      |       |   | — |   |   |   | 111,944 |   |   |   | — |   |   |
| German Long-Term  Bank Facilities maturing  through 2018 |       |                                                                | 9,820      |                      |       |   | 18,952 |   |   |   | 4,577 |   |   |   | 33,030 |   |   |
| Multicurrency  Term Loan Facility due through 2015            |       |                                                                | —     |                      |       |   | 75,556 |   |   |   | — |   |   |   | — |   |   |
| U.S. 1997 Senior  Notes, due through 2007                     |       |                                                                | 4,000      |                      |       |   | 4,000 |   |   |   | 4,000 |   |   |   | 8,000 |   |   |
| U.S. 2000 Senior  Notes, due through 2010                     |       |                                                                | —     |                      |       |   | 35,000 |   |   |   | — |   |   |   | 35,000 |   |   |
| Other Borrowings                                              |       |                                                                | 182        |                      |       |   | 1,944 |   |   |   | 938 |   |   |   | 466 |   |   |
| Total                                                         |       |                                                                | $          | 168,548                   |       |   |   | $ | 135,452 |   |   |   | $ | 244,987 |   |   |   | $ | 76,496 |   |   |

 

*Multicurrency andNon-U.S. Bank Facilities*

In December 2005 the Company entered into aMulticurrency Revolving Facility Agreement (the Agreement). Under the Agreementthe Company may borrow up to $250,000 through December 2010. Debt issuancecosts of approximately $700 were capitalized and are being amortized tointerest expense over the Agreement’s five-year term. Due to the fact that thisagreement includes a material adverse 

F-15

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(7) Long-TermDebt: (Continued)**

change clause and anyamounts drawn under the facility must be repaid or reborrowed within360 days, all amounts outstanding under this facility are classified ascurrent.

Borrowings under the Agreement bear interest at a ratebased on either the relevant interbank offering rate plus a margin (0.75% at December 31,2005), Federal Funds plus 0.5%, or the prevailing Prime Rate. The margin on theinterbank offering rate option ranges from 0.5% to 1.125%, depending upon theCompany’s ratio of net debt to EBITDA, as defined. The weighted averageinterest rate on outstanding borrowings under the Agreement was approximately4.3% at December 31, 2005. The Company is also required to pay acommitment fee on the unused portion of the Agreement. The commitment fee ratevaries depending upon the Company’s ratio of net debt to EBITDA, as defined. Asof December 31, 2005, this fee was 0.175% and the Company had incurredcommitment fee expense of $12 in 2005. The Agreement contains certain financialcovenants relating to the Company’s EBITDA to net interest expense and net debtto EBITDA, as defined. The Company was in compliance with the covenants at December 31,2005.

The Agreement was a modification of the MulticurrencyRevolving Credit Facility Agreement that the Company had entered into in September 2003(the Prior Agreement) under which the Company could have borrowed up to$250,000. All borrowings under the Prior Agreement, except a portion of theGerman long-term debt that was treated as a reduction of the available fundsunder this facility, were classified as current due to the fact that thisagreement included a material adverse change clause and any amounts drawn underthis facility had to be repaid or reborrowed within 360 days.

Borrowings under the Prior Agreement  were at an interest rate based upon therelevant interbank offering rate plus a margin ranging from 0.65% to 1.65%,depending on the Company’s ratio of net debt to EBITDA, as defined. The Companywas required to pay a commitment fee on the unused portion of the PriorAgreement. The commitment fee rate varied depending upon the Company’s ratio ofnet debt to EBITDA, as defined. The Company incurred $468 and $787 ofcommitment fee expense related to the Prior Agreement in 2005 and 2004,respectively.

The Company also maintains a revolving credit facilityof 800,000 Danish kroner that is available through June 2006. At December 31,2005 the Company had 447,149 Danish Kroner or $71,254 available under thisfacility. The interest rate  on the loansoutstanding at December 31, 2005 was 3.4%. In addition, the Company isrequired to pay a commitment fee on the unused portion of this credit facility,which was at a rate of 0.50% at December 31, 2005. The Company incurred$71 and $19 of expense in 2005 and 2004, respectively as a result of thiscommitment fee. This facility requires the Company to maintain certain minimumlevels of equity and EBITDA to net interest, as defined. The Company was incompliance with the requirements at December 31, 2005.

The German Long-Term Bank Facilities represent aseries of long-term and short-term bank loans. Included in the balance of$28,772 are loans with approximately $14,700 outstanding at December 31,2005 that are secured by property. Interest on the German facilities may beeither fixed or variable depending on the individual loan. Interest rates rangefrom 2.6% to 6.6% at December 31, 2005. These facilities contain a varietyof repayment schedules and have final maturities ranging from June 2006through June 2018.

F-16

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

In December 2005 theCompany borrowed $75,000 under a new term loan facility. The Company borrowed $30,000 in U.S. Dollars at afixed interest rate of 5.74% and 38,450 euro at a fixed interest rate of 4.05%over the ten year term of the loan. Repayments are scheduled fromDecember 2011 through December 2015. The outstanding balance on thisloan at December 31, 2005 was $75,556. The Agreement contains certainfinancial covenants relating to the Company’s EBITDA to net interest expenseand net debt to EBITDA, as defined, which the Company was in compliance with atDecember 31, 2005.

*U.S. Borrowings*

In December 1997, the Company issued $25,000 of6.68% Senior Notes (1997 Senior Notes), of which $8,000 remains outstanding atDecember 31, 2005. The 1997 Senior Notes have remaining repayments onDecember 15, 2006 and 2007. The 1997 Senior Notes contain certainrestrictions and require the maintenance of minimum tangible net worth andmaximum leverage, as defined. At December 31, 2005, the Company was incompliance with these requirements.

In October 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, 2005 the Company was in compliance with theserequirements.

The Company maintains overdraft facilities in variouscurrencies in multiple countries totaling $76,500 for cash management purposes.The interest rates and commitment fees vary by country and arrangement. AtDecember 31, 2005 there was $28,275 outstanding under these facilities.

Payments required to be made on long-term debtoutstanding as of December 31, 2005 during the years ending 2006 through2010 and for years thereafter, are $168,548, $12,899, $14,205, $13,128,$14,662, and $80,558, 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, 2005 and 2004.

*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 pensionliabilities reflected in the accompanying consolidated balance sheets resultprincipally from unfunded pension plans of the Company’s operations in Germany,where it is common practice to fund pension obligations at the time paymentsare made to retirees, and the unfunded portion of the U.S. plan.

F-17

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(8) Pension and Postretirement Benefitsother than Pensions: (Continued)**

Pension expense for 2005, 2004, and 2003 for thesedefined benefit plans consists of the following components:

| ** **                         | ** ** | **December 31,** | ** ** |
|------------------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Service cost                       |       | $                     | 4,516      |   | $ | 4,250 |   | $ | 4,001 |   |
| Interest cost                      |       | 10,559                |       | 9,945 |   | 9,054 |   |
| Expected return  on plan assets    |       | (8,226                | )          | (7,528 | ) | (6,811 | ) |
| Amortiation of  prior service cost |       | 526                   |       | 530 |   | 657 |   |
| Amortization of  net loss          |       | 2,362                 |       | 1,476 |   | 630 |   |
| Net periodic  pension expense      |       | $                     | 9,737      |   | $ | 8,673 |   | $ | 7,531 |   |

 

The following tablesets forth the plans’ funded status as of the respective balance sheet dates:

| ** **                                        | ** ** | **December 31,** | ** ** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|------------|
| ** **                                        | ** ** | **2005**              | ** ** | **2004**   | ** ** | ** ** |   |
| **Reconciliation of benefit  obligation:**        |       |                  |       |       |   |   |
| Benefit  obligation at January 1             |       | $                     | (196,149   | )          | $ | (165,536 | ) |   |
| Service cost                                      |       | (4,516                | )          | (4,250     | ) |   |
| Interest cost                                     |       | (10,559               | )          | (9,945     | ) |   |
| Plan participant  contributions                   |       | (456                  | )          | (463       | ) |   |
| Plan amendments                                   |       | (238                  | )          | —     |   |   |
| Actuarial loss                                    |       | (16,217               | )          | (16,326    | ) |   |
| Benefit payments                                  |       | 8,696                 |       | 6,818      |   |   |
| Effect of  exchange rate changes                  |       | 10,530                |       | (6,447     | ) |   |
| Benefit  obligation at December 31           |       | $                     | (208,909   | )          | $ | (196,149 | ) |   |
| **Reconciliation of fair value of  plan assets:** |       |                  |       |       |   |   |
| Fair value of  plan assets at January 1      |       | 116,138               |       | 100,888    |   |   |
| Actual return on  plan assets                     |       | 13,254                |       | 10,978     |   |   |
| Employer  contributions                           |       | 15,963                |       | 6,594      |   |   |
| Effect of  exchange rate changes                  |       | (4,221                | )          | 2,477      |   |   |
| Plan participant  contributions                   |       | 456                   |       | 463        |   |   |
| Benefit payments                                  |       | (7,211                | )          | (5,262     | ) |   |
| Fair value of  plan assets at December 31    |       | 134,379               |       | 116,138    |   |   |
| Funded status at  December 31                |       | (74,530               | )          | (80,011    | ) |   |
| Unrecognized  actuarial loss                      |       | 46,233                |       | 38,607     |   |   |
| Unrecognized  prior service cots                  |       | 1,511                 |       | 3,364      |   |   |
| Net amount recognized                             |       | $                     | (26,786    | )          | $ | (38,040 | ) |   |
|                                                   |            |                       |            |            |  |  |  |  |  |  |  |  |  |

 

F-18

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

Amounts recognized in theconsolidated balance sheets as of:

| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Long-term pension  liability, net (1)   |       | $                     | (37,549    | ) | $ | (51,407 | ) |
| Current pension  liability              |       | (5,049                | )          | (4,590 | ) |
| Intangible asset                        |       | 1,665                 |       | 3,459 |   |
| Accumulated other  comprehensive income |       | 14,147                |       | 14,498 |   |
| Net amount recognized                   |       | $                     | (26,786    | ) | $ | (38,040 | ) |

----

(1)          Includes plan assets of$12,041 and $5,741 in 2005 and 2004, respectively for the U.K. plan that isincluded in other assets.

Significantassumptions used in determining pension expense and related pension obligationsare as follows:

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2005**              | ** ** | **2004** | ** ** | **2003** | ** ** |
| Discount Rates                               |       |                  |       |   |   |   |   |
| United States                                |       | 5.75                  | %          | 6.00 | % | 6.25 | % |
| Germany                                      |       | 4.50                  |       | 4.75 |   | 5.30-6.00 |   |
| United Kingdom                               |       | 4.66                  |       | 5.25 |   | 5.50 |   |
| Rates of increase  in compensation levels    |       |                  |       |   |   |   |   |
| United States                                |       | 3.50                  |       | 3.50 |   | 3.50 |   |
| Germany                                      |       | 2.00                  |       | 2.50 |   | 2.50 |   |
| United Kingdom                               |       | 3.90                  |       | 4.00 |   | 4.00 |   |
| Expected  long-term rate of return on assets |       |                  |       |   |   |   |   |
| United States                                |       | 8.50                  |       | 8.50 |   | 8.50 |   |
| United Kingdom                               |       | 5.86                  |       | 6.20 |   | 6.00 |   |

 

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 58% in equity securities, 40% in fixed incomesecurities, and 2% in cash. This allocation is expected to earn an averageannual rate of return of approximately 5.86%.

The discount rate assumptions were based on investmentyields available on AA rated long-term corporate bonds with cash flows that aresimilar to expected benefit payments.

The expected return on plan assets is based on theasset allocation mix and the historical return, taking into account current andexpected market conditions.

F-19

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

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** | ** ** |
|-------------------|------------|--------------------|------------|--------------------|------------|
| ** **        | ** ** | **2005**           | ** ** | **2004**           | ** ** | **2005** | ** ** | **2004** | ** ** |
| Equity securities |       |               | 62         | %                  |       |   | 60 | % |   |   | 48 | % |   |   | 61 | % |   |
| Debt securities   |       |               | 35         | %                  |       |   | 37 | % |   |   | 34 | % |   |   | 38 | % |   |
| Other             |       |               | 3          | %                  |       |   | 3 | % |   |   | 18 | % |   |   | 1 | % |   |
| Total             |       |               | 100        | %                  |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

 

During December 2005the Company contributed approximately $8,600 to the U.K. Plan funds, which wereheld in a high-interest cash deposit account temporarily pending a review oflong-term investment strategy.

*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 non-U.S. operations, where applicable, are providedthrough government-sponsored plans to which the Company contributes fundsduring the individuals’ employment periods.

The components ofthe postretirement benefit expense of the Company-sponsored health benefitplans for 2005, 2004, and 2003, were as follows:

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service cost                    |       | $        | 553        |     | $          | 621      |       | $ | 539 |   |
| Interest cost                   |       | 1,876    |       | 1,753    |       | 1,636    |       |
| Net deferral and  amortization  |       | 693      |       | 543      |       | 322      |       |
| Postretirement benefit  expense |       | $        | 3,122      |     | $          | 2,917    |       | $ | 2,497 |   |

 

F-20

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

The funded status of theCompany-sponsored health benefit plans was as follows:

| ** **                                                        | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Reconciliation  of benefit obligation:**                        |       |                  |       |   |   |
| Accumulated  postretirement benefit liability at January 1   |       | $                     | (29,502    | ) | $ | (27,153 | ) |
| Service cost                                                      |       | (553                  | )          | (621 | ) |
| Interest cost                                                     |       | (1,876                | )          | (1,753 | ) |
| Actuarial loss                                                    |       | (4,494                | )          | (2,102 | ) |
| Benefit payments                                                  |       | 2,206                 |       | 2,127 |   |
| Accumulated  postretirement benefit liability at December 31 |       | (34,219               | )          | (29,502 | ) |
| **Reconciliation of fair value of plan assets:**                  |       |                  |       |   |   |
| Fair value of  plan assets at January 1                      |       | —                |       | — |   |
| Employer  contributions                                           |       | 2,206                 |       | 2,127 |   |
| Benefit payments                                                  |       | (2,206                | )          | (2,127 | ) |
| Fair value of  plan assets at December 31                    |       | —                |       | — |   |
| Funded status                                                     |       | (34,219               | )          | (29,502 | ) |
| Unrecognized  actuarial loss                                      |       | 14,758                |       | 10,957 |   |
| Postretirement benefit  obligation                                |       | $                     | (19,461    | ) | $ | (18,545 | ) |

 

The assumed weighted average annual rate of increasein the per capita cost of medical benefits is 10.0% for 2006 and is assumed todecrease ratably in 2007 through 2011 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, 2005, by $2,189, andincreased or decreased postretirement benefit expense for 2005 by $194. Theweighted average discount rate used to estimate the accumulated postretirementbenefit obligation was 5.75%, 6.0%, and 6.25% for 2005, 2004, and 2003, respectively.

F-21

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

The benefits expected to be paid from the benefitplans, which reflect expected future years of service, and the Medicare subsidyexpected to be received are as follows:

| ** **   | ** ** | **Pensions** | ** ** | **Health Care** | ** ** | **Health care  subsidy receipts  (1)** | ** ** |
|--------------|------------|--------------|------------|----------------------|------------|--------------------------------------------------|------------|
| 2006         |       | $            | 7,259      |                 |       | $                                                | 1,772      |   |   |   | $ | 70 |   |   |
| 2007         |       | 7,880        |       |                 | 2,022      |                                             |       |   | 81 |   |   |
| 2008         |       | 8,424        |       |                 | 2,202      |                                             |       |   | 84 |   |   |
| 2009         |       | 9,026        |       |                 | 2,404      |                                             |       |   | 89 |   |   |
| 2010         |       | 9,684        |       |                 | 2,569      |                                             |       |   | 95 |   |   |
| 2011 to 2015 |       | 59,442       |       |                 | 15,053     |                                             |       |   | 497 |   |   |
|              |            |              |            |                      |            |                                                  |            |  |  |  |  |  |  |  |

----

(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 $8,100to the Company pension and health benefit plans in 2006.

The Company also maintainstwo defined contribution plans, the Sauer-Danfoss Employees’ Savings Plan andthe Sauer-Danfoss LaSalle Factory Employee Savings Plan, for eligibleemployees. Company contributions include both base and matching amounts. TheCompany contributed approximately $2,200 to these plans in 2005 and $1,900 tothese plans in both 2004 and 2003.

**(9) Income Taxes:**

TheCompany’s income (loss) before income taxes is as follows:

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| United States       |       | $                                           | 5,790      |   | $ | (4,973 | ) | $ | (26,545 | ) |
| European and  other |       | 43,917                                      |       | 53,894 |   | 37,304 |   |
| Total               |       | $                                           | 49,707     |   | $ | 48,921 |   | $ | 10,759 |   |

 

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-22

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

Thebenefit (expense) for income taxes by taxing jurisdiction is as follows:

| ** **                          | ** ** | **Years Ended December 31,** | ** ** |
|-------------------------------------|------------|---------------------------------------------|------------|
| ** **                          | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current                             |       |                                        |       |   |   |   |   |
| United States                       |       |                                        |       |   |   |   |   |
| Federal                             |       | $                                           | (414       | ) | $ | 2,411 |   | $ | — |   |
| State                               |       | 357                                         |       | (100 | ) | — |   |
| European and other                  |       | (23,722                                     | )          | (21,294 | ) | (8,403 | ) |
| Total Current                       |       | (23,779                                     | )          | (18,983 | ) | (8,403 | ) |
| Deferred                            |       |                                        |       |   |   |   |   |
| United States                       |       |                                        |       |   |   |   |   |
| Federal                             |       | 7,594                                       |       | 3,130 |   | 6,519 |   |
| State                               |       | 252                                         |       | (563 | ) | 1,179 |   |
| European and other                  |       | 4,941                                       |       | 681 |   | 1,179 |   |
| Total Deferred                      |       | 12,787                                      |       | 3,248 |   | 8,877 |   |
| Total income tax benefit  (expense) |       | $                                           | (10,992    | ) | $ | (15,735 | ) | $ | 474 |   |

 

Areconciliation of tax expense calculated using the U.S. statutory tax rate andrecorded income tax expense based on the Company’s income before income taxes isas follows:

| ** **                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                         | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Tax expense based  on U.S. statutory tax rate                                      |       | $                                           | (17,398    | ) | $ | (17,124 | ) | $ | (3,765 | ) |
| Deferred tax  benefit not previously recognized                                    |       | 4,355                                       |       | — |   | 1,886 |   |
| Reduction of  income tax accrued liability                                         |       | —                                      |       | 2,600 |   | — |   |
| Statutory tax  rate change                                                         |       | 1,072                                       |       | — |   | — |   |
| Tax Holiday in  China                                                              |       | 539                                         |       | 251 |   | — |   |
| Tax on Dividend  repatriation under AJCA                                           |       | (829                                        | )          | — |   | — |   |
| European and  Asian locations’ losses not tax benefit                         |       | (627                                        | )          | (1,435 | ) | (424 | ) |
| Taxes on non-U.S.  locations’ income at rates which differ from the U.S. rate |       | 2,690                                       |       | 3,806 |   | 1,473 |   |
| State income  taxes                                                                |       | 396                                         |       | (431 | ) | 766 |   |
| Tax effect of  minority interest                                                   |       | (914                                        | )          | (900 | ) | (730 | ) |
| Other                                                                              |       | (276                                        | )          | (2,502 | ) | 1,268 |   |
| Total income tax benefit  (expense)                                                |       | $                                           | (10,992    | ) | $ | (15,735 | ) | $ | 474 |   |

 

F-23

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(9) IncomeTaxes: (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,** | ** ** |
|-----------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                        | ** ** | **2005**              | ** ** | **2004** | ** ** |
| ** **                                                                        | ** ** | **Assets**            | ** ** | **Liabilities** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** |
| Net operating  loss (NOL) and tax credit carryforwards                            |       | $                     | 26,122     |   | $ | — |   | $ | 27,214 |   | $ | — |   |
| Deferred  compensation, post-retirement medical and accrued pension benefits |       | 20,996                |       | (953 | ) | 23,631 |   | — |   |
| Fixed asset basis  differences                                                    |       | 7,250                 |       | (30,688 | ) | 1,684 |   | (32,784 | ) |
| Inventory and  warranty accruals                                                  |       | 10,177                |       | (1,958 | ) | 8,385 |   | (3,913 | ) |
| Intangible asset  fair market value step-up                                       |       | 10,748                |       | (10,909 | ) | 12,467 |   | (11,507 | ) |
| Other items                                                                       |       | 11,658                |       | (4,060 | ) | 5,262 |   | (250 | ) |
| Gross deferred  tax assets/liabilities                                            |       | 86,951                |       | (48,568 | ) | 78,643 |   | (48,454 | ) |
| Valuation  allowance                                                              |       | (30,808               | )          | — |   | (34,706 | ) | — |   |
| Net deferred tax  assets/liabilities                                              |       | 56,143                |       | (48,568 | ) | 43,937 |   | (48,454 | ) |
| Less current  portion                                                             |       | (13,272               | )          | 4,291 |   | (10,947 | ) | — |   |
| Net deferred tax  assets/liabilities, long-term                                   |       | $                     | 42,871     |   | $ | (44,277 | ) | $ | 32,990 |   | $ | (48,454 | ) |

 

The U.S. NOL carryforward tax benefits were recordedthrough 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 tax benefitsof such recognition will reduce goodwill. Approximately $17,500 and $5,700 ofthe valuation allowance is related to the acquired NOL carryforwards and toforeign tax and research credits, respectively. See further discussion of thetax return carryforwards below.

As of December 31, 2005 and 2004, the Company hadnot provided U.S. federal income taxes on $122,934 and $190,629 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.

TheCompany had the following tax return carryforwards available to offset futureyears’ taxable income at December 31, 2005:

| ** **                                            | ** ** | **Amount** | ** ** | **Expiration Dates** | ** **     |
|-------------------------------------------------------|------------|------------|------------|---------------------------|----------------|
| German NOL —  National                      |       | $          | 54,023     |                      |           | None |   |   |
| German NOL —  Local                         |       | 3,321      |       |                      | None           |   |   |
| U.S. NOL                                              |       | 50,587     |       |                      | 2006—2019 |   |   |
| Other non-U.S.  NOL                                   |       | 11,193     |       |                      | 2006—2014 |   |   |
| Foreign Tax credits  (available to offset U.S. taxes) |       | 6,255      |       |                      | 2011—2014 |   |   |
|                                                       |            |            |            |                           |                |  |  |  |

 

F-24

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

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 assessmentincluding invoicing of costs to non-U.S. locations related to the commonbusiness system and discontinuance of LIFO method of valuing inventory for atotal of $12,400. Based on these factors, management believes it is more likelythan not that the Company will realize benefits of the net deferred tax assetsas of December 31, 2005.

The American Jobs Creation Act of 2004 introduced alimited time 85% dividends received deduction on the repatriation of certain foreignearnings to a U.S. taxpayer, provided certain criteria are met. During 2005 thecompany recognized a tax expense of $829 related to repatriation of foreignearnings under this provision.

The Company’s resolved theIRS audit of its federal income tax returns for years 1997 through 2001 during2005. The Company reduced its expense for income taxes by $335 in 2005 toreflect the final settlement.

**(10) MinorityInterests:**

Minority interests in net assets and income reflectedin the accompanying consolidated financial statements consists of:

a)               A 40% minorityinterest held by Agri-Fab, Inc. in Hydro-Gear Limited Partnership, a U.S.limited partnership, for 2005, 2004, and 2003.

b)              A 40% minorityinterest held by Shanghai Hydraulics and Pneumatics in Sauer Shanghai HydraulicTransmission Co., Ltd., a Chinese equity business venture for 2005, 2004,and 2003.

c)               A 35% minorityinterest held by Daikin Industries Ltd. inSauer-Danfoss-Daikin, Ltd., a Japanese corporation, for 2005, 2004, and2003.

d)              A 49.9% minorityinterest held by Topcon Laser Systems in TSD Integrated Controls LLC, a U.S.limited partnership, for 2005, 2004, and 2003.

e)               A 55% minorityinterest held by Daikin Industries Ltd. in Daikin-Sauer-DanfossManufacturing, Ltd., a Japanese corporation, for 2005 and 2004. Prior to2004 this entity was accounted for under the equity method but was consolidatedin 2004 in accordance with the requirements of FIN No. 46R as discussed inNote 1.

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

F-25

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(10) MinorityInterests: (Continued)**

The following tables setforth the components of minority interest in the consolidated balance sheets:

| ** **                                     | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-----------------------|------------|
| ** **                                     | ** ** | **2005**              | ** ** | **2004** | ** ** |
| Hydro-Gear  Limited Partnership                |       | $                     | 33,586     |   | $ | 25,467 |   |
| Sauer Shanghai  Hydraulic Transmission Company |       | 4,357                 |       | 3,248 |   |
| Sauer-Danfoss-Daikin,  Ltd                     |       | 7,765                 |       | 6,452 |   |
| TSD Integrated  Controls LLC                   |       | 847                   |       | 687 |   |
| Daikin-Sauer-Danfoss  Manufacturing, Ltd.      |       | 4,885                 |       | 4,073 |   |
| Total                                          |       | $                     | 51,440     |   | $ | 39,927 |   |

 

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 Both Liabilitiesand Equity,” management of the Company has estimated the current market valueof the partnership. Based on this estimate, if the partnership were toterminate the Company would distribute approximately $87,000 to the minorityinterest 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 equal to7.6% of the income of Sauer Inc. and subsidiaries before taxes and theMurmann Limited Partnership Interests and the right to consent to certainactions of the German Operating Company. However, the Company had the right toelect by the action of its independent directors or the holders of its commonstock other than the Murmann family to terminate the Murmann LimitedPartnership Interests in exchange for 2,250 shares of common stock ofSauer Inc. As such, the Company controlled and consolidated the GermanOperating 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, $14,092 at December 31, 2005, using an exchange rate of 1.18 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.

F-26

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(11) AccumulatedOther Comprehensive Income:**

The changes inaccumulated other comprehensive income for the years ended December 31,2003, 2004 and 2005 follows:

| ** **                            | ** ** | **Currency  Translation** | ** ** | **Pension  Adjustment** | ** ** | **Hedging  Activities** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** |
|---------------------------------------|------------|---------------------------|------------|-------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| Balance as of  January 1, 2003   |       |                      | $          | 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 |   |   |
| Change in period                      |       |                      | (34,584    | )                       |       |                    | 787        |                                          |       |   | 301 |   |   |   | (33,496 | ) |   |
| Income tax  benefit                   |       |                      | —     |                    |       |                    | (695       | )(1)                                          |       |   | (109 | ) |   |   | (804 | ) |   |
| Balance as of  December 31, 2005 |       |                      | $          | 39,242                  |       |                    |       | $                                             | (11,553    | ) |   |   | $ | (279 | ) |   |   | $ | 27,410 |   |   |

----

(1)          Represents tax effect onGerman pension amounts, not previously tax-effected related to net operatingloss carryforwards.

**(12) DerivativeFinancial Instruments:**

The Company recognizes allderivative financial instruments, such as foreign exchange contracts, in theconsolidated financial statements at fair value in accordance with SFAS No. 133,“Accounting for Derivative Instruments and Hedging Activities.” The Company hasentered into forward contracts to hedge the value of the U.S. dollar cash flowat locations that do not have the U.S. dollar as their functional currency butconduct certain transactions in U.S. dollars. The objective of all outstandingforward contracts is to hedge forecasted transactions in U.S. dollars throughthe cash settlement date. The Company enters forward contracts that mature fromtwo to eighteen months after the contract date.

Changes in the fair value of derivative financialinstruments are recognized in income or in stockholders’ equity as a componentof comprehensive income depending on whether any transaction related to thehedged risk has occurred. Changes in fair values of derivatives that areaccounted for as cash flow hedges are recorded in other comprehensive income. Anyportion of the hedge that is deemed ineffective due to the absolute value ofthe cumulative change in the derivative being greater than the cumulativechange in the hedged item is recorded immediately in other income (expense) onthe consolidated statement of income. There was no hedge ineffectiveness in2005. Any changes in fair values of derivatives not qualifying as hedges arereported immediately in other income (expense) on the consolidated statement ofincome; however, the Company did not have any derivatives that did not qualifyas hedges in 2005.

Thefair value estimates used to value the foreign exchange contracts are based oninformation available to management and were determined using quoted marketprices and the discounted value of future cash flows.

F-27

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(12) Derivative FinancialInstruments: (Continued)**

During the year ended December 31,2005, accumulated other comprehensive income increased by $17 due to new cashflow hedges entered during 2005.

At December 31, 2005the Company expects to reclassify $17 of gains on derivative instruments fromaccumulated other comprehensive income to earnings during the next twelvemonths due to the actual fulfillment of forecasted transactions.

**(13) Long-Term IncentivePlan:**

The Company’s Long-TermIncentive Plan (the Plan) provides for the grant of stock options, stockappreciation rights, restricted stock, performance units, performance shares,and other incentive awards to officers and key employees. The total number ofshares of common stock that may be subject to awards or be issued under thePlan shall not exceed 2,400,000 shares, of which no more than 1,200,000 sharesmay be issued as restricted stock. The settlement of performance units is inshares of company stock or cash as determined by the Compensation Committee ofthe Board of Directors. The performance units entitle the participants toreceive an amount equal to the Company’s dividends during the vesting period.

The following chart summarizes performance unitactivity under the Plan for the year ended December 31, 2005:

| ** **                             | ** ** | **Number** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** | **Weighted Average  Vesting Period  in Years** | ** ** |
|----------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Units Outstanding  at January 1   |       | $          | 696,230    |                                                        |       | $                                                             | 17.34      |   |   |   | 2.5 |   |   |
| Units paid                             |       | (56,308    | )          |                                                        | 19.40      |                                                          |       |   | 1.0 |   |   |
| Units granted                          |       | 324,017    |       |                                                        | 21.26      |                                                          |       |   | 3.0 |   |   |
| Units forefeited                       |       | (15,910    | )          |                                                        | 18.48      |                                                          |       |   | 2.7 |   |   |
| Units Outstanding at  December 31 |       | 948,029    |       |                                                        | 18.42      |  (1)                                                     |       |   | 2.8 |   |   |
|                                        |            |            |            |                                                             |            |                                                               |            |  |  |  |  |  |  |

----

(1)          Theweighted average fair value at December 31, 2005 was adjusted to reflectthe modification of the original award discussed below.

In February 2005 theCompensation Committee of the Board of Directors determined that performanceunits outstanding, after settlement of the awards related to the 2004performance, would be settled 100% in company stock with a value withheld tomeet the minimum statutory withholding requirements of the Company in thecountries where the individual participants pay tax. In accordance with SFAS No. 123R,“Share-Based Payment,” this change was a modification of the original award andtherefore these units are being accounted for as equity units with compensationexpense recognized based on the fair value of the Company’s stock price at themodification date. The liability accrued in previous years related to themodified performance units was reclassified to additional paid-in-capital atthe time the awards were modified.

In February 2004the Board of Directors approved granting approximately 323,000 performanceunits under the Plan to replace all performance units and stock optionspreviously granted, as the original targets established for those grants wereno longer deemed reasonable due to unforeseen economic conditions. In addition,on that date, the Board of Directors approved granting approximately 385,000 

F-28

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

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

additional performanceunits under the Plan. In 2004 compensation cost related to the units to bedistributed in company stock and in cash had been recognized based on the fairvalue of the equity instruments at the performance unit grant date and fairvalue at December 31, 2004, respectively. During 2003 the Company awarded306,000 performance units to employees. As noted above, the 2004 performanceunits awarded replaced the performance units awarded in 2003.

Compensation expenserecognized in selling, general, and administrative expenses in conjunction withthe performance units outstanding was $9,499, $10,458, and $368 in 2005, 2004,and 2003, respectively. The tax benefits recognized related to this expense was$3,506, $4,125, and $0 in 2005, 2004, and 2003, respectively.

In March 2003 theBoard granted 339,000 stock options to certain members of management. Asdiscussed above, the stock options were replaced by performance units in 2004.The Company 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.

The Company also has aNon-employee Director Stock Option and Restricted Stock Plan which permits thegranting of non-qualified stock options and restricted common stock todirectors of the Company who are not employees of the Company. The total numberof shares of common stock to be issued under this plan shall not exceed 250,000shares.

Under the Non-employeeDirector Stock Option and Restricted Stock Plan the Company awarded,13,500 shares of restricted stock to non-employee directors in 2005, 2004,and 2003. The restricted stock awards entitle the participants to full dividendand voting rights. Unvested shares are restricted as to disposition and subjectto forfeiture under certain circumstances. The value of each award wasestablished based on the market value of the stock as of the grant date. Theshares vest over three years. Prior to the adoption of SFAS No. 123R,unearned compensation related to the restricted stock was shown as a reductionof stockholders’ equity. The Company adopted SFAS No. 123R using amodified prospective application which requires that any unearned compensationrelated to awards prior to the adoption of SFAS No. 123R be eliminatedagainst the appropriate equity account on the consolidated balance sheet.Compensation expense is computed based on the market value of the restrictedshares at the grant date, which is amortized ratably over the vesting period ofthe grants. Compensation expense recognized in conjunction with the restrictedstock outstanding in 2005, 2004, and 2003 amounted to $184, $128, and $98,respectively.

**(14) RelatedParty 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 paid ona monthly basis. Total expense recognized for goods and services purchased fromDanfoss A/S for 2005, 2004, and 2003 was approximately $52,900, $51,800,and $47,300, respectively. At December 31, 2005 approximately $8,000 owedto Danfoss, A/S is included in accounts payable on the consolidated balancesheet. Payments required under these agreements as of December 31, 2005,during 

F-29

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(14) Related Party Transactions:(Continued)**

theyears ending 2006 though 2010 and for years thereafter, are $6,500, $6,364,$6,275, $6,261, $6,261, and $27,131, respectively.

The Company purchasesinventory components from Shanghai Hydraulics and Pneumatics, a minorityinterest owner in an entity included in the Company’s consolidated financialstatements. Purchases were approximately $3,300, $2,600, and $1,600 in 2005,2004, and 2003, respectively.

In addition, the Companysold product totaling approximately $5,400 and $6,000 in 2005 and 2004,respectively, to Daikin Industries Ltd. (Daikin), a minority interest owner inan entity consolidated by the Company. The Company also purchases inventorycomponents and ongoing operational services from Daikin. These services includeshared facilities and administrative support. Total expense recognized forgoods and services purchased from Daikin in 2005 and 2004 were approximately$6,600 and $6,900, respectively.

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. In 2005 the Company also contributed $350 to ascience park principally sponsored by a shareholder of Danfoss A/S. Inaddition, the Company had sales to Faun Umwelttechnik GmbH & Co., acompany owned by a director, of $900 and $800 in 2005 and 2004, respectively.

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

The Company leases certainfacilities and equipment under operating leases, many of which contain renewaloptions. Total rental expense on all operating leases during 2005, 2004, and2003 was $18,368, $19,615, and $15,132, respectively. Rent is expensed on astraight-line basis over the term of the leases.

Minimum future rentalcommitments under all noncancelable operating leases as of December 31,2005, during the years ending 2006 through 2010 and for the years thereafter,are $11,650, $7,402, $4,120, $3,090, $2,874, and $25,327, respectively.

The Company also leasescertain facilities and equipment under capital leases. The liability related tothese capital leases is included in current other accrued liabilities and otherlong-term liabilities on the consolidated balance sheets. Minimum future leasepayments under all noncancelable capital leases as of December 31, 2005,during the years ending 2006 through 2010 and for the years thereafter, are$1,666, $988, $988, $988, $988, and $13,390, respectively.

The Company, from time totime, 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 outcome of these matters in which it is currentlyinvolved will not have a materially adverse effect on its results ofoperations, liquidity or financial position.

F-30

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(16) Quarterly FinancialData (Unaudited): (Continued)**

Summarizedquarterly data is set forth in the following table:

| ** **                                                | ** ** | **Quarter** | ** ** |
|-----------------------------------------------------------|------------|-------------|------------|
| ** **                                                | ** ** | **First**   | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| **2005**                                                  |       |        |       |   |   |   |   |   |   |   |   |
| Net sales                                                 |       | $           | 422,585    |   | $ | 438,096 |   | $ | 342,032 |   | $ | 345,103 |   | $ | 1,547,816 |   |
| Gross profit                                              |       | 98,988      |       | 109,376 |   | 76,205 |   | 73,177 |   | 357,746 |   |
| Net income                                                |       | 10,810      |       | 19,562 |   | 4,292 |   | 4,051 |   | 38,715 |   |
| Basic net income  per common share                   |       | $           | 0.23       |   | $ | 0.41 |   | $ | 0.09 |   | $ | 0.09 |   | $ | 0.82 |   |
| Diluted net  income per common share                      |       | $           | 0.23       |   | $ | 0.41 |   | $ | 0.09 |   | $ | 0.08 |   | $ | 0.81 |   |
| **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 |   |

----

(1)          Basic and diluted netincome (loss) per common share is computed independently for each of theperiods presented. Accordingly, the sum of the quarterly basic and diluted netincome (loss) per common share may not agree to the annual total.

**(17)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 asconsulting for special projects, tax and accounting fees paid to outside thirdparties, certain insurance premiums, and amortization of intangible assets fromcertain business combinations.

The accounting policies of the segments are the sameas those described in the summary of significant accounting policies. TheCompany evaluates individual segment performance based on segment income or 

F-31

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(17) Segmentand Geographic Information: (Continued)**

loss defined as the respective segment’s portion ofthe total 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, 2005, 2004, and 2003,respectively:

| ** **                           | ** ** | **Propel** | ** ** | **Work  Function** | ** ** | **Controls** | ** ** | **Global  Services** | ** ** | **Total** | ** ** |
|--------------------------------------|------------|------------|------------|--------------------|------------|--------------|------------|----------------------|------------|-----------|------------|
| **2005**                             |       |       |       |               |       |         |       |                 |       |      |       |
| Trade sales                          |       | $          | 751,134    |               | $          | 430,668      |       | $                    | 366,014    |      | $          | — |   | $ | 1,547,816 |   |
| Segment income  (loss)               |       | 106,376    |       | 6,345              |       | 31,436       |       | (60,140              | )          | 84,017    |       |
| Interest expense                     |       |       |       |               |       |         |       |                 |       | (17,540   | )          |
| Interest income                      |       |       |       |               |       |         |       |                 |       | 1,887     |       |
| Minority interest  and equity income |       |       |       |               |       |         |       |                 |       | (18,657   | )          |
| Income before  income taxes          |       |       |       |               |       |         |       |                 |       | 49,707    |       |
| Depreciation and  amortization       |       | 38,636     |       | 27,408             |       | 17,190       |       | 5,088                |       | 88,322    |       |
| Total assets                         |       | 397,950    |       | 321,738            |       | 256,958      |       | 194,267              |       | 1,170,913 |       |
| Capital  expenditures                |       | 39,285     |       | 33,043             |       | 19,454       |       | 3,465                |       | 95,247    |       |
| **2004**                             |       |       |       |               |       |         |       |                 |       |      |       |
| Trade sales                          |       | $          | 656,482    |               | $          | 412,046      |       | $                    | 335,631    |      | $          | — |   | $ | 1,404,159 |   |
| Segment income  (loss)               |       | 89,992     |       | 20,840             |       | 24,680       |       | (47,654              | )          | 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       |       | 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       |       | 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    |       |

 

F-32

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2005, 2004, and 2003 (Dollars in thousands, except per share data)**

**(17) Segmentand 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)** | ** ** |
|-----------------|------------|-----------------------------|------------|-------------------------------------|------------|
| ** **      | ** ** | **2005**                    | ** ** | **2004**                            | ** ** | **2003** | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States   |       | $                           | 679,849    |                                | $          | 598,007 |   | $ | 455,520 |   | $ | 174,201 |   | $ | 169,896 |   |
| Germany         |       | 145,521                     |       | 134,513                             |       | 108,654 |   | 56,687 |   | 77,267 |   |
| Italy           |       | 100,641                     |       | 100,072                             |       | 82,663 |   | 28,222 |   | 34,006 |   |
| France          |       | 80,596                      |       | 76,142                              |       | 60,963 |   | 912 |   | 1,092 |   |
| Japan           |       | 76,766                      |       | 60,896                              |       | 43,820 |   | 4,591 |   | 3,962 |   |
| United Kingdon  |       | 58,054                      |       | 57,448                              |       | 50,420 |   | 23,340 |   | 23,290 |   |
| Sweden          |       | 60,239                      |       | 52,475                              |       | 42,788 |   | 5,906 |   | 6,731 |   |
| Denmark (3)     |       | 22,747                      |       | 22,187                              |       | 19,020 |   | 188,109 |   | 203,173 |   |
| Slovakia (3)    |       | 1,370                       |       | 1,223                               |       | 1,021 |   | 54,419 |   | 58,117 |   |
| Other countries |       | 322,033                     |       | 301,196                             |       | 261,905 |   | 79,435 |   | 74,945 |   |
| Total           |       | $                           | 1,547,816  |                                | $          | 1,404,159 |   | $ | 1,126,774 |   | $ | 615,822 |   | $ | 652,479 |   |

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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 other long-livedassets.

(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.

**(18) Subsequent Event(unaudited):**

On March 1, 2006 the Company announced itsintention to close the LaSalle, Illinois facility, which is primarily amachining facility for the Propel segment. The Company plans to outsource amajority of the processes currently being performed in LaSalle. Based oninitial estimates, the Company anticipates incurring approximately $8,000 -$10,000 in charges related to the closing of this facility.

F-33

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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 report on Form 10-K.Sauer-Danfoss believes that the consolidated financial statements have beenprepared in conformity with accounting principles generally accepted in theUnited 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 ofSponsoring Organizations of the Treadway Commission (COSO). Based on ourevaluation under the framework in Internal Control — Integrated Framework,our management concluded that our internal control over financial reporting waseffective as of December 31, 2005.

**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,and earnings 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-34

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**Codeof Legal and Ethical Business Conduct**

TheSauer-Danfoss Code of Legal and Ethical Business Conduct is based not justsolely on what we have a right to do, but even more importantly, on what is theright thing to do. Annually, we reiterate the vital importance of our Code ofLegal and Ethical Business Conduct by requiring employees is key functionalareas to certify their compliance with the standards of the Code.
| David J. Anderson                 | Karl J. Schmidt                                   |
|----------------------------------------|--------------------------------------------------------|
| President and  Chief Executive Officer | Executive Vice President and   Chief Financial Officer |

 

F-35

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**Reportof Independent Registered Public Accounting Firm**

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, 2005 and 2004, 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, 2005. 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 31,2005 and 2004, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2005in conformity with U.S. generally accepted accounting principles.

Asdescribed in note 13 to the consolidated financial statements, in 2003 theCompany changed its method of accounting for stock compensation expense.

We also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2005, 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 10,2006, expressed an unqualified opinion on management’s assessment of, andeffective operation of, internal control over financial reporting.
| Des Moines, Iowa    |
|---------------------|
| March 10, 2006 |

 

F-36

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**Report ofIndependent Registered Public Accounting Firm**

The Board of Directors andStockholders of Sauer-Danfoss Inc:

We have audited management’sassessment, included in the accompanying Management’s Report on InternalControl Over Financial Reporting appearing under Item 9A, that Sauer-DanfossInc. (a Delaware corporation) and subsidiaries (the Company) maintainedeffective internal control over financial reporting as of December 31,2005, based on criteria established in *Internal Control — IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO). The Company’s management is responsible formaintaining effective internal control over financial reporting and for itsassessment of the effectiveness of internal control over financial reporting.Our responsibility is to express an opinion on management’s assessment and anopinion on the effectiveness of the Company’s internal control over financialreporting based on our audit.

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether effective internal control overfinancial reporting was maintained in all material respects. Our audit includedobtaining an understanding of internal control over financial reporting,evaluating management’s assessment, testing and evaluating the design andoperating effectiveness of internal control, and performing such otherprocedures as we considered necessary in the circumstances. We believe that ouraudit provides a reasonable basis for our opinion.

A company’s internalcontrol over financial reporting is a process designed to provide reasonableassurance regarding the reliability of financial reporting and the preparationof financial statements for external purposes in accordance with generallyaccepted accounting principles. A company’s internal control over financialreporting includes those policies and procedures that (1) pertain to themaintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally acceptedaccounting principles, and that receipts and expenditures of the company arebeing made only in accordance with authorizations of management and directorsof the company; and (3) provide reasonable assurance regarding preventionor timely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with the policiesor procedures may deteriorate.

In our opinion, management’sassessment that Sauer-Danfoss Inc. and subsidiaries maintained effectiveinternal control over financial reporting as of December 31, 2005, isfairly stated, in all material respects, based on criteria established in *Internal Control — Integrated Framework* issued by theCommittee of Sponsoring Organizations of the Treadway Commission (COSO). Also,in our opinion, the Company maintained in all material respects, effectiveinternal control over financial reporting as of December 31, 2005, basedon criteria established in *Internal Control — IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO).

F-37

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We also have audited, in accordance with the standardsof the Public Company Accounting Oversight Board (United States), theconsolidated balance sheets of Sauer-Danfoss Inc. and subsidiaries as of December 31,2005 and 2004, 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, 2005, and our report dated March 10,2006 expressed an unqualified opinion on those consolidated financialstatements.
| /s/  KPMG LLP        |
|----------------------|
| Des Moines, Iowa     |
| March  10, 2006 |

 

F-38

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**Schedule IISauer-Danfoss Inc. and SubsidiariesValuation and Qualifying AccountsYears Ended December 31, 2003, 2004, and 2005(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, 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 |   |   |
| For the year ended  December 31, 2005  |       |                                         |       |                                          |       |                                                       |       |                                       |       |                                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful  accounts            |       |                                         | $          | 4,671                                         |       |                                                       |       | 1,178                                      |       |                                           |       | (349                                   | )          |   |   | — |   |   |   | (600 | ) |   |   | $ | 4,900 |   |   |

 

F-39

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

To the Shareholders of Sauer-Danfoss Inc.:

Under date of March 10, 2006, we reported on theconsolidated balance sheets of Sauer-Danfoss Inc. and subsidiaries as of December 31,2005 and 2004, 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, 2005, 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, the financial statement schedule, whenconsidered in relation to the 2005, 2004, and 2003 basic consolidated financialstatements taken as a whole, presents fairly, in all material respects, theinformation set forth therein.

As discussed in Note 13 to the consolidated financialstatements, the Company changed its method of accounting for stock compensationexpense.

We also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control overfinancial reporting as of December 31, 2005, 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 10, 2006, expressed an unqualifiedopinion on  management’s assessment of,and effective operation of, internal control over financial reporting.

/s/ KPMG LLP

DesMoines, Iowa

March 10, 2006

F-40

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