**SECURITIES AND EXCHANGE COMMISSION**Washington, DC 20549

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**FORM 10-K**

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

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006COMMISSION FILE NUMBER: 1-14097**

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**SAUER-DANFOSS INC.**(Exactname of registrant as specified in its charter)

| **Delaware**                                                      | ** ** | **36-3482074**                              |
|-------------------------------------------------------------------|------------|---------------------------------------------|
| (State or other jurisdiction of  incorporation or organization)   |       | (I.R.S. Employer  Identification No.)       |
| **250 Parkway Drive,  Suite 270,  Lincolnshire, Illinois**   | ** ** | **60069**                                   |
| **Krokamp 35, 24539  Neumünster, Germany**                   | ** ** | ** **                                  |
| (Address of principal executive offices)                          |       | (Zip Code)                                  |
| **(515) 239-6000**                                           |
| (Registrant’s telephone number, including Area Code)         |
| Securities registered pursuant to Section 12(b)  of the Act: |
| Common Stock, par value  $0.01 per share                          |       | New York Stock Exchange                     |
| (Title of each class)                                             |       | (Name of each exchange on which registered) |
| Securities registered  pursuant to Section 12(g) of the Act: |
| **None**                                                          |
| (Title of class)                                                  |

 

Indicateby check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405of the Securities Act of 1933. Yes o No x

Indicateby check mark if the registrant is not required to file reports pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934 (the “Act”). Yes o No x

Indicateby check mark whether the registrant: (1) has filed all reports requiredto be filed by Section 13 or 15(d) of the Act during the preceding 12months (or for such shorter periods that the Registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x No o

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to thebest of registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K: x

Indicateby check mark whether the registrant is a large accelerated filer, acceleratedfiler, or a non-accelerated filer. See definition of “accelerated filer andlarge accelerated filer” in Rule 12b-2 of the Act. (Check one):

Large AcceleratedFiler o         Accelerated Filer x         Non-Accelerated Filer o

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act): Yes o No x

Theaggregate market value of the voting common stock of the registrant held bynonaffiliates based on the last sale price on June 30, 2006 was$266,136,368. (The registrant does not have any other authorized common equity.)

As ofMarch 9, 2007 there were 48,125,961 shares of common stock, $0.01 parvalue, of the registrant outstanding.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the Proxy Statement for the annual meeting of stockholders to be held June 14,2007 are incorporated by reference into Part III.

 

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**PART I**

**Item 1.   Business.**

**(a)   GeneralDevelopment of Business**

Sauer-Danfoss Inc.(the Company), a U.S. 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 reportsits operating segments based on its product lines of Propel, Work Function, andControls. 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-33through F-35 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 and geographicregions is set forth in Note 17 in the Notes to Consolidated FinancialStatements on pages F-33 through F-35, and is incorporatedherein by reference. No individual customer, OEM or other, accounted for10 percent or more of the Company’s total net sales in 2006, 2005, or2004.

***PropelSegment***

**HydrostaticTransmissions**

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; Princeton,Kentucky; Freeport, Illinois; Neumunster, Germany; Dubnica nad Vahom, Slovakia;Povazská Bystrica, Slovakia; Shanghai, China; and Osaka, Japan.

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**Open Circuit PistonPumps**

Sauer-Danfoss designs,manufactures, and markets custom-designed open circuit piston pumps used totransform mechanical power from the engine to hydraulic power for the variousfunctions 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 Dubnica, Slovakia.

***WorkFunction Segment***

**Open Circuit GearPumps 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.

**Low Speed HighTorque 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 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.

***ControlsSegment***

**Mobile Electronics**

Sauer-Danfoss designs, manufactures, and marketselectronic controls including microprocessor-based controls, electronicsensors, and joysticks through its electrohydraulics operations in Minneapolis,Minnesota, and Almhult, Sweden, and also designs electrohydraulic products inNeumunster, Germany; Redditch, United Kingdom; Cento, Italy; and Nordborg,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’shydraulic systems, as well as the hydraulic systems of other manufacturers. Theelectrohydraulic products bring together the propulsion and work functions byproviding standard or custom-designed controls.

Additionally, the Companydesigns and manufactures both alternating current (AC) and direct current (DC)electric motors, electronic motor controllers, and power units through itselectric drives operations in Odense, Denmark and Berching, Germany. TheKaiserslautern, Germany, facility designs inverters used to control the ACelectric motors 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** | ** ** | **Material Handling and  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                   |       |                          |       |                                          |

 

**GeneralCharacteristics**

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 24 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 warranty expensehas been less than one percent of net sales in each of the past three 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 Company’s sales locations maintain inventory thatconsist primarily of finished units manufactured specifically for distributionto 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 2006 the availability of steel improved, but was still limited. The Companywas still able to obtain sufficient quantities of steel and castings to meetits production needs. The cost of these materials was higher than in the pastyears due to continued limited supplies and metal surcharges. The Company has aglobal supplier quality program that is used by the Company to ensure allsuppliers meet the Company’s quality expectations.

**Patents,Trademarks, and Licenses**

The Company owns or licenses rights to approximately600 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.

**Working Capital**

The Company hashistorically funded its working capital requirements through cash flow from operationsand its various credit facilities.

**Backlog**

At December 31, 2006the Company’s backlog (consisting of accepted but unfilled customer ordersprimarily scheduled for delivery during 2007) was $632 million, anincrease of 19 percent from 

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December 31,2005, excluding the impact of currency fluctuation. The amount of the Company’sbacklog is significant because, among other factors, customer orders havehistorically involved long lead times and specific model types. Orders can beincreased, canceled, or rescheduled by customers causing the backlog level tovary. In addition, customers’ ordering patterns can impact the level ofreported backlog. For example, the Company’s U.S. distributor customers areplacing orders with shorter lead times due to the Company’s ability to fillsuch orders.

**Competition**

The mobile hydraulicsindustry is very competitive. Sauer-Danfoss competes based on technologicalproduct innovation, quality, and customer service. The Company believes that tobe successful over the long term, suppliers to mobile equipment manufacturersmust have the ability to capitalize on the changing needs of the industry byproviding technological innovation, shorter product development times, andreduced manufacturing lead times at globally competitive price levels.

*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 competes worldwidethat are not captive suppliers of OEMs. These include Bosch Rexroth AG,Eaton Corporation, and Linde AG. In addition, the Company competes withalternative products, such as mechanical transmissions of other manufacturers.

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 

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electroniccontrol of steering and complete electrical steering solutions to meet thegrowing demands of the steering market. Today, Sauer-Danfoss believes that it leadsthe industry in this direction for steering technology.

*Mobile ElectronicsMarket*

In the mobile electronicsmarket, which covers both propulsion and work function systems, there are fewsuppliers of propulsion system controls and only three are worldwidecompetitors. The main competition in this area comes from major OEMs, whoproduce controls for their own use. In work function electrohydraulic valves,electronic sensors, and controls, there is a wide range of niche suppliers inlimited geographic markets. In recent years larger companies have increasinglyacquired these niche or regional suppliers and thereby have improved theirability to offer integrated systems. The Company also produces alternatingcurrent (AC) and direct current (DC) motors and controls and is well equippedto serve customers in these segments with either a hydraulic solution or anelectric solution for their propel and work function needs. The Companybelieves it is well positioned to establish itself as a technology leader in thework function and propel segments, as there is no clearly establishedtechnology in this sector that is deemed to be an industry standard.

*Control ValvesMarket*

The control valvemarketplace is fragmented with a large number of suppliers most of which arefocused 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 andDevelopment**

The Company’s research anddevelopment expenditures during 2006, 2005, and 2004 were approximately$61.9 million, $58.7 million, and $51.9 million, respectively.

**EnvironmentalMatters**

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 31,2006, 2005, and 2004 the Company had approximately 9,200, 8,600, and 8,300,employees, respectively. Of its full time employees at December 31, 2006,approximately 3,100 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-33through F-35 of this report, and is incorporated herein by reference.

**AvailableInformation**

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 to Section 13(a) ofthe Securities Exchange Act of 1934 through its Internet website as soon asreasonably practicable after the Company electronically files such materialwith, or furnishes it to, the Securities and Exchange Commission (SEC). The SECmaintains an Internet Website that contains reports, proxy and informationstatements, and other information regarding issuers that file electronicallywith the SEC. The address of the SEC site is http://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.

**InternationalOperations**

The Company depends on thestrength of the economies in various parts of the world, particularly in theU.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,construction and 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.

**Implementation ofNew 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 MaterialAvailability**

The Company purchases rawmaterials and component parts from suppliers to be used in the manufacture ofproducts. Changes in relationships with suppliers or increases in the costs ofpurchased raw materials including steel and other metals, and component partscould result in manufacturing 

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interruptions,delays, inefficiencies, or the inability to market products. In addition,profit margins would decrease if prices of purchased raw materials or componentparts increase and the Company is unable to pass on those increases to itscustomers.

**Pricing andCompetitive Pressures from OEM Customers**

A majority of the Company’ssales are directly to OEM customers. Increasingly, OEM customers are seeking touse their positions as volume purchasers in the mobile hydraulics market toobtain preferential pricing and to obtain substantial quality assuranceprotection from suppliers.

**Currency ExchangeRates**

The Company has a number ofmanufacturing sites throughout the world and sells products in severalcountries other than those where the product is manufactured. As a result, theCompany has exposure to movements in the exchange rates of various currenciesagainst the U.S. dollar and against the currencies of countries in which themain manufacturing facilities are located. The Company’s most significantforeign currency exposures are the euro, Japanese yen, Slovakian koruna, Polishzloty, and Danish kroner. Exchange rate fluctuations relative to the U.S.dollar could adversely affect the Company’s results of operations. The Companydoes enter into forward contracts to reduce the impact of currency fluctuationson cash flows related to forecasted sales denominated in currencies other thanthe functional currency of the selling location.

**Cyclicality: RisksAssociated 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 economicrecession in the U.S. or Europe or any other major industrial market couldcause a substantial decrease in the Company’s net sales and have a materialadverse effect on the Company’s business, financial conditions and results ofoperations.

**Income TaxEstimates**

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 outcome 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. In 2007 the Company will adoptFinancial Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109” (FIN No. 48),which requires that a tax position have a greater than 50 percentlikelihood of being sustained in order to 

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recognizein the financial statements. The Company does not expect the adoption of FIN No. 48to have a significant impact on its consolidated financial statements.

**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 forhydraulic and electric products and make it difficult or impossible for theCompany to manufacture products, deliver products to customers, or to receiveproducts 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.

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**Item 2.   Properties.**

Sauer-Danfoss Inc.conducts its manufacturing operations at 24 locations; eight 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. Inaddition, the Company has executive offices in Neumünster, Germany. 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                                   |
| 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 |       | 354,500                                                |       | Owned                                   |
| Dubnica nad Váhom,  Slovakia |         | Propel                              |       | 250,000                                                |       | Owned                                   |
| Bologna, Italy                    |         | Work Function                       |       | 246,000                                                |       | 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                             |         |                                |       | 4,113,000                                              |       |                                    |

 

**Item 3.   LegalProceedings.**

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

11

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

**Item 4.   Submissionof Matters to a Vote of Security Holders.**

The Company did not submitany matter to a vote of security holders, through a solicitation of proxies orotherwise, during the fourth quarter of 2006.

**EXECUTIVE OFFICERSOF THE COMPANY**

Thefollowing table sets forth certain information regarding the executive officersof the Company:
| Name                    | ** ** | ** ** | ** ** | **Age**                                                        | ** ** | **Position** | ** ** | **Year  Appointed** |
|-------------------------|------------|------------|------------|----------------------------------------------------------------|------------|--------------|------------|---------------------|
| David J. Anderson (1)   |       | 59         |       | President and Chief  Executive Officer                         |       | 2000         |
| Hans J. Cornett (1)     |       | 56         |       | Executive Vice President  Chief Marketing Officer              |       | 2000         |
| Thomas K. Kittel (1)    |       | 58         |       | Executive Vice President  and President Propel Division        |       | 2000         |
| Karl J. Schmidt (2)     |       | 53         |       | Executive Vice President  and Chief Financial Officer          |       | 2002         |
| James R. Wilcox (1)     |       | 61         |       | Executive Vice President  and President Work Function Division |       | 2000         |
| Ronald C. Hanson (3)    |       | 44         |       | Vice President —  Human Resources                    |       | 2003         |
| Henrik Krabsen (1)      |       | 45         |       | Vice President —  Valves                             |       | 2000         |
| Finn H. Lyhne (1)       |       | 52         |       | Vice President —  Electric Drives                    |       | 2000         |
| Kenneth D. McCuskey (1) |       | 52         |       | Vice President and Chief  Accounting Officer, Secretary        |       | 2000         |
| Albert K. Zahalka (1)   |       | 55         |       | Vice President —  Mobile Electronics                 |       | 2000         |
| Charles M. Cohrs (4)    |       | 44         |       | Treasurer                                                      |       | 2005         |

----

(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.

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**PART II**

**Item 5.**                        Marketfor the Company’s Common Stock. Related Stockholder Matters and CompanyPurchases of Common Stock.

*Market and DividendInformation*

The Company’s Common Stock is traded on the New YorkStock Exchange. Prior to February 2006 the Company’s common stock was alsotraded on the Frankfurt (Germany) Stock Exchange. As of March 2, 2007there were 205 stockholders of record.

The Company is currently paying a quarterly dividend,which is subject to Board of Directors approval.

Thefollowing table sets forth the high and low prices on the New York StockExchange for the Company’s Common Stock since January 1, 2005, and thequarterly cash dividends declared in 2006 and 2005:

| ** ** | ** ** | **1st**    | ** ** | **2nd**    | ** ** | **3rd**    | ** ** | **4th**    | ** ** | **Full Year** | ** ** |
|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|--------------------|------------|
| **2006**   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |               | ** ** | ** ** |   |
| High       |       | $          | 23.13      |       | $          | 25.98      |       | $          | 26.53      |               | $          | 33.56 |   |   | $ | 33.56 | ** ** |   |
| Low        |       | $          | 18.79      |       | $          | 21.55      |       | $          | 22.22      |               | $          | 23.80 |   |   | $ | 18.79 | ** ** |   |
| Dividends  |       | $          | 0.14       |       | $          | 0.14       |       | $          | 0.16       |               | $          | 0.16 |   |   | $ | 0.60 | ** ** |   |
| **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 | ** ** |   |

 

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*Performance Graph*

The following graph showsa comparison of the cumulative total returns from December 31, 2001 to December 31,2006, for the Company, the Russell 2000 Index and the Hemscott, Inc. —Diversified Machinery Index (“Hemscott-Group Index”). The graph assumes that$100 was invested on December 31, 2001 in the Company’s common stock, theRussell 2000 Index and the Hemscott-Group Index, a peer group index, and thatall dividends were reinvested.

**COMPARECUMULATIVE TOTAL RETURNAMONG SAUER-DANFOSS INC.RUSSELL 2000 INDEX AND HEMSCOTT GROUP INDEX**

****

14

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**Equity CompensationPlan Information**

Thefollowing table summarizes, as of December 31, 2006, information aboutcompensation plans under which equity securities of the Company are authorizedfor issuance:

| **Plan Category**                                  | ** ** | ** ** | ** ** | **Number of securities to  be Issued upon Exercise  of Outstanding Options,  Warrants and Rights  (a)** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights  (b)** | ** ** | **Number of Securities Remaining  Avaliable for Future Issuance  under Equity Compensation  Plans (Excluding Securities  Reflected in Column (a))  (c)** | ** ** |
|---------------------------------------------------------|------------|------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| Equity  compensation plans approved by security holders |       |       | 1,342,504  |                                                                                                                                                      |       |                                                                                                             | $          | 0.00                                                                                                                                                                                                                      |       |   |   | 4,280,435 |   |   |
|                                                         |            |            |            |                                                                                                                                                           |            |                                                                                                                  |            |                                                                                                                                                                                                                           |            |  |  |  |  |  |  |  |

 

The Company does not have any equity compensationplans that were not approved by security holders. Refer to Note 13 in theNotes to the Consolidated Financial Statements on pages F-29 throughF-31 of this report for a description of the equity compensation plans.

Column (a) includes performance units granted in2004, 2005, and 2006. The extent to which the performance goals established foreach grant are met will determine how many shares of common stock are issuedupon completion of the three year performance period. Subsequent to December 31,2006, the Company’s Compensation Committee determined that the 2004 performanceunits would vest, based on satisfaction of the performance criteria establishedwhen such units were awarded, at 190 percent of the target levels.Therefore, included in the above amounts are the 2004 performance units at190 percent and the 2005 and 2006 performance units at 100 percent ofthe target levels.

Column (c) includes 868,754 shares availablefor future issuance under the Company’s 1998 Long-Term Incentive Plan,167,000 shares available for issuance under the Company’s Non-EmployeeDirector Stock Option and Restricted Stock Plan, and 3,244,681 sharesavailable for issuance under the Company’s 2006 Omnibus Incentive Plan. Each ofthese plans permits the Company to issue common stock at times other than uponthe exercise of options, warrants, or rights; for example, issuance in the formof restricted stock grants.

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**Item 6.**                        SelectedFinancial Data.

**SELECTEDFINANCIAL DATA**

| ** **                                                 | ** ** | **2006**                                                                                | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                 | ** ** | **(in millions except per share and employee data)** | ** ** |
| **Operating Data:**                                        |       |                                                                                    |       |       |       |       |       |       |       |       |       |
| Net Sales                                                  |       | $                                                                                       | 1,739.1    |       | $          | 1,547.8    |       | $          | 1,404.2    |       | $          | 1,126.8 |   | $ | 952.3 |   |
| Gross profit                                               |       | 396.8                                                                                   |       | 357.7      |       | 346.1      |       | 252.4      |       | 219.0      |       |
| Selling, general  and administrative                       |       | 215.6                                                                                   |       | 217.1      |       | 200.2      |       | 156.7      |       | 128.6      |       |
| Research and  development                                  |       | 61.9                                                                                    |       | 58.7       |       | 51.9       |       | 43.4       |       | 37.8       |       |
| Impairment  charges and loss on disposal of   fixed assets |       | 3.2                                                                                     |       | 1.4        |       | 2.1        |       | 5.3        |       | 0.4        |       |
| Total operating  expenses                                  |       | 280.7                                                                                   |       | 277.2      |       | 254.2      |       | 205.4      |       | 166.8      |       |
| Total interest  expense, net                               |       | 17.8                                                                                    |       | 15.7       |       | 17.4       |       | 17.4       |       | 17.2       |       |
| Net income                                                 |       | 53.7                                                                                    |       | 38.7       |       | 33.2       |       | 11.2       |       | 13.7       |       |
| **Per Share Data:**                                        |       |                                                                                    |       |       |       |       |       |       |       |       |       |
| Income per common  share, basic                            |       | $                                                                                       | 1.13       |       | $          | 0.82       |       | $          | 0.70       |       | $          | 0.24 |   | $ | 0.29 |   |
| Income per common  share, diluted                          |       | $                                                                                       | 1.11       |       | $          | 0.81       |       | $          | 0.70       |       | $          | 0.24 |   | $ | 0.29 |   |
| Cash dividends  declared per share                         |       | $                                                                                       | 0.60       |       | $          | 0.48       |       | $          | 0.34       |       | $          | 0.28 |   | $ | 0.28 |   |
| Weighted average  basic shares outstanding                 |       | 47.7                                                                                    |       | 47.5       |       | 47.4       |       | 47.4       |       | 47.4       |       |
| Weighted average  diluted shares outstanding               |       | 48.2                                                                                    |       | 47.8       |       | 47.5       |       | 47.5       |       | 47.4       |       |
| **Balance Sheet Data:**                                    | ** ** | ** **                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Inventories                                                |       | $                                                                                       | 272.3      |       | $          | 238.9      |       | $          | 241.6      |       | $          | 198.9 |   | $ | 164.7 |   |
| Property, plant  and equipment, net                        |       | 504.0                                                                                   |       | 450.4      |       | 478.5      |       | 452.9      |       | 435.1      |       |
| Total assets                                               |       | 1,309.2                                                                                 |       | 1,170.9    |       | 1,211.6    |       | 1,101.8    |       | 970.5      |       |
| Total debt                                                 |       | 349.6                                                                                   |       | 332.3      |       | 345.1      |       | 355.5      |       | 318.3      |       |
| Stockholders’  equity                                 |       | 466.0                                                                                   |       | 438.9      |       | 444.1      |       | 397.2      |       | 367.3      |       |
| Debt to total  capital (1)                                 |       | 40.2                                                                                    | %          | 40.4       | %          | 41.6       | %          | 45.3       | %          | 44.7       | %          |
| **Other Data:**                                            | ** ** | ** **                                                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Backlog (at  year-end)                                     |       | $                                                                                       | 632.4      |       | $          | 504.2      |       | $          | 467.4      |       | $          | 408.6 |   | $ | 382.8 |   |
| Depreciation and  amortization                             |       | 95.7                                                                                    |       | 88.3       |       | 82.4       |       | 80.4       |       | 72.6       |       |
| Capital  expenditures                                      |       | 116.2                                                                                   |       | 95.2       |       | 79.3       |       | 60.0       |       | 42.3       |       |
| EBITDA (2)                                                 |       | 206.1                                                                                   |       | 172.3      |       | 170.2      |       | 124.0      |       | 121.8      |       |
| Cash flows from (used  in):                                |       |                                                                                    |       |       |       |       |       |       |       |       |       |
| Operating activities                                       |       | 167.9                                                                                   |       | 116.3      |       | 124.8      |       | 95.6       |       | 98.3       |       |
| Investing activities                                       |       | (109.3                                                                                  | )          | (93.3      | )          | (75.5      | )          | (65.0      | )          | (66.3      | )          |
| Financing activities                                       |       | (45.0                                                                                   | )          | (20.1      | )          | (53.3      | )          | (28.8      | )          | (34.4      | )          |
| Number of employees (at  year end)                         |       | 9,167                                                                                   |       | 8,614      |       | 8,275      |       | 7,409      |       | 7,207      |       |

----

(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. While EBITDAshould 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:

| ** **                                                                                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|
| Cash flows from  operating activities                                                           |       | $        | 167.9      |     | $          | 116.3    |       | $        | 124.8      |     | $          | 95.6 |   | $ | 98.3 |   |
| Cumulative effect  of change in accounting   principle                                          |       | —   |       | —   |       | —   |       | —   |       | (0.7     | )          |
| Increase (decrease) in operating  assets and liabilities, excluding the effects of acquisitions |       |     |       |     |       |     |       |     |       |     |       |
| Accounts receivable, net                                                                        |       | 24.5     |       | 4.8      |       | 30.8     |       | 5.6      |       | (2.8     | )          |
| Inventories                                                                                     |       | 14.2     |       | 24.9     |       | 23.5     |       | 7.6      |       | (1.1     | )          |
| Accounts payable                                                                                |       | (27.2    | )          | 13.3     |       | (22.7    | )          | (6.1     | )          | (2.5     | )          |
| Accrued liabilities                                                                             |       | (8.5     | )          | (17.6    | )          | (10.2    | )          | (6.2     | )          | (4.1     | )          |
| Deferred income taxes and other                                                                 |       | 0.1      |       | 3.9      |       | (9.1     | )          | 10.6     |       | 10.3     |       |
| Interest expense,  net                                                                          |       | 17.8     |       | 15.7     |       | 17.4     |       | 17.4     |       | 17.2     |       |
| Tax expense  (benefit)                                                                          |       | 17.3     |       | 11.0     |       | 15.7     |       | (0.5     | )          | 7.2      |       |
| EBITDA                                                                                          |       | $        | 206.1      |     | $          | 172.3    |       | $        | 170.2      |     | $          | 124.0 |   | $ | 121.8 |   |

 

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**Item 7.**                        Management’sDiscussion and Analysis of Financial Condition and Results of Operations.

**Safe HarborStatement**

*This Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, as well as other portions ofthis annual report on Form 10-K, contain statements that constitute “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995. Forward-looking statements provide current expectations of futureevents based on certain assumptions and include any statement that does notdirectly relate to any historical or current fact. All statements regardingfuture performance, growth, sales and earnings projections, conditions ordevelopments are forward-looking statements. Words such as “anticipates,” “inthe opinion,” “believes,” “intends,” “expects,” “may,” “will,” “should,” “could,”“plans,” “forecasts,” “estimates,” “predicts,” “projects,” “potential,” “continue,”and similar expressions may be intended to identify forward-looking statements.*

*Actual future results may differ materially fromthose described in the forward-looking statements due to a variety of factors,including the fact material handling and specialty markets have, in recentmonths, been stronger than in recent years. It is difficult to determine ifpast experience is a good guide to the future. While the economy in the U.S.was strong in the first half of the year it weakened in the second half of theyear. The economic situation in Europe has begun to improve in the last half ofthe year although that improvement may not necessarily continue. The economy inChina strengthened in 2006 after a sluggish 2005. Any downturn in the Company’sbusiness segments could adversely affect the Company’s revenues and results ofoperations. Other factors affecting forward-looking statements include, but arenot limited to, the following: specific economic conditions in the agriculture,construction, road building, turf care, material handling and specialty vehiclemarkets and the impact of such conditions on the Company’s customers in suchmarkets; the cyclical nature of some of the Company’s businesses; the abilityof the Company to win new programs and maintain existing programs with itsoriginal equipment manufacturer (OEM) customers; the highly competitive natureof the markets for the Company’s products as well as pricing pressures that mayresult from such competitive conditions; the continued operation and viabilityof the Company’s significant customers; the Company’s execution of internalperformance plans; difficulties or delays in manufacturing; cost-reduction andproductivity efforts; competing technologies and difficulties entering newmarkets, both domestic and foreign; changes in the Company’s product mix;future levels of indebtedness and capital spending; claims, including, withoutlimitation, warranty claims, field retrofit claims, product liability claims,charges or dispute resolutions; ability of suppliers to provide materials asneeded and the Company’s ability to recover any price increases for materialsand product pricing; the Company’s ability to attract and retain key technicaland other personnel; labor relations; the failure of customers to make timelypayment; any inadequacy of the Company’s intellectual property protection orthe potential for third-party claims of infringement; global economic factors,including currency exchange rates; general economic conditions, includinginterest rates, the rate of inflation, and commercial and consumer confidence;energy prices; governmental laws and regulations affecting operations,including tax obligations; changes in accounting standards; worldwide politicalstability; the effects of terrorist activities and resulting political oreconomic instability; natural catastrophes; U.S. military action overseas; andthe effect of acquisitions, divestitures, restructurings, product withdrawals,and other unusual events.*

*TheCompany cautions the reader that these lists of cautionary statements and riskfactors may not be exhaustive. The Company expressly disclaims any obligationor undertaking to release publicly any updates or changes to theseforward-looking statements that may be made to reflect any future events orcircumstances.*

**About the Company**

Sauer-Danfoss Inc.and subsidiaries (the Company) is a worldwide leader in the design,manufacture, and sale of engineered hydraulic and electronic systems andcomponents that generate, transmit and control power in mobile equipment. TheCompany’s products are used by original equipment manufacturers (OEMs) ofmobile equipment, including construction, road building, agricultural, turfcare, material handling, and specialty equipment. The Company designs,manufactures, and markets its products 

18

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in theAmericas, Europe, and the Asia-Pacific region, and markets its productsthroughout the rest of the world either directly or through distributors.

**Executive Summaryof 2006 Compared to 2005**

Thenature of the Company’s operations as a global producer and supplier in thefluid power industry means the Company is impacted by changes in 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 2005 to 2006. This analysis is moreconsistent with how the Company’s management internally evaluates results.

| **(in millions)**                                     | ** ** | ** ** | ** ** | **2005** | ** ** | **Currency  Fluctuations** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2006** | ** ** |
|------------------------------------------------------------|------------|------------|------------|----------|------------|----------------------------|------------|--------------------------------------|------------|----------|------------|
| Net Sales                                                  |       | $          | 1,547.8    |     |       | $                          | 7.9        |                                 |       |     | $          | 183.4 |   |   | $ | 1,739.1 |   |
| Gross Profit                                               |       | 357.7      |       |     | 1.9        |                       |       |                                 | 37.2       |     |       | 396.8 |   |
| % of Net Sales                                             |       | 23.1       | %          |     |       |                       |       |                                 |       |     |       | 22.8 | % |
| Selling, general  and administrative                       |       | 217.1      |       |     | 1.2        |                       |       |                                 | (2.7       | )        |       | 215.6 |   |
| Research and  development                                  |       | 58.7       |       |     | 0.3        |                       |       |                                 | 2.9        |     |       | 61.9 |   |
| Impairment  charges and loss on   disposal of fixed assets |       | 1.4        |       |     | —     |                       |       |                                 | 1.8        |     |       | 3.2 |   |
| Total operating costs                                      |       | 277.2      |       |     | 1.5        |                       |       |                                 | 2.0        |     |       | 280.7 |   |
| Operating income                                           |       | 80.5       |       |     | 0.4        |                       |       |                                 | 35.2       |     |       | 116.1 |   |
| % of Net Sales                                             |       | 5.2        | %          |     |       |                       |       |                                 |       |     |       | 6.7 | % |
| Net interest  expense                                      |       | (15.7      | )          |     | (0.1       | )                          |       |                                 | (2.0       | )        |       | (17.8 | ) |
| Other expense,  net                                        |       | 3.5        |       |     | (0.2       | )                          |       |                                 | (9.0       | )        |       | (5.7 | ) |
| Income before taxes and minority interest                  |       | 68.3       |       |     | 0.1        |                       |       |                                 | 24.2       |     |       | 92.6 |   |
| Minority interest                                          |       | (18.6      | )          |     | $          | —                     |       |                                 |       | $        | (3.0       | ) |   | (21.6 | ) |
| Earnings before taxes                                      |       | 49.7       |       |     | 0.1        |                       |       |                                 | 21.2       |     |       | 71.0 |   |
| % of Net Sales                                             |       | 3.2        | %          |     |       |                       |       |                                 |       |     |       | 4.1 | % |
| Income tax benefit (expense)                               |       | (11.0      | )          |     | 0.2        |                       |       |                                 | (6.5       | )        |       | (17.3 | ) |
| Net income                                                 |       | $          | 38.7       |     |       | $                          | 0.3        |                                 |       |     | $          | 14.7 |   |   | $ | 53.7 |   |
|                                                            |            |            |            |          |            |                            |            |                                      |            |          |            |  |  |  |  |  |  |  |  |  |

 

The underlying growth in sales, excluding the effectof currency fluctuations, was approximately 12 percent in 2006. Sales wereup in all regions and all segments with increases of 11 percent in theAmericas, 13 percent in Europe and 12 percent in Asia-Pacific,excluding the impact of currency. The increase in sales was due to overallstrong economic conditions, price increases and higher sales volumes. Grossprofit margin on total net sales decreased due to several factors, includingrestructuring costs incurred, costs incurred for the transfer of productionlines, labor costs for overtime worked to meet the high demand for product, andcosts to expedite product to meet customer demand.

Selling, general and administrative costs decreased1 percent during 2006 when compared to the same period in 2005. Costsassociated with the implementation of a common company wide business systemwere $13.7 million in 2006, a decrease of $3.4 million compared to2005. Costs incurred in 2006 were related to implementation of the system atseven U.S. locations, one Danish location, two Slovakian locations as well asimplementations in process in China, Italy and several Scandinavian salescompanies. Outside service costs related to the assessment of internal controlsunder Section 404 of the Sarbanes-

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Oxley Act of 2002 alsodecreased $3.4 million. These reductions were partially offset by generalprice increases.

During the first quarter of 2006 the Company announcedplans to close the LaSalle, Illinois plant, to discontinue the production ofcertain product lines currently manufactured in the Swindon, England plant, andto restructure certain activities in the Propel and Controls segments. TheCompany incurred a total of $13.5 million in restructuring charges inconnection with these plans during 2006, $10.9 million was included incost of sales and $0.5 million in selling, general and administrativeexpenses and $2.1 million was loss on disposal of fixed assets. Costsincurred include employee termination costs of $3.8 million, impairmentand loss on disposal of fixed assets of $2.1 million, accelerateddepreciation of $2.1 million, pension curtailment costs of$1.6 million, facilities moving costs of $1.4 million, and other costsof $2.5 million. The restructuring costs as a percent of sales were0.8 percent in 2006.

In 2006 the Companyrecognized $5.7 million of other expense, primarily related to foreigncurrency losses. During 2005 the Company recognized $3.5 million of other income,primarily related to foreign currency gains. The combined negative currencyimpact of $9.0 million in 2006 is due to the weakening of the U.S. dollarthroughout 2006.

**Operating Results —2006 Compared to 2005**

***SalesGrowth by Market***

Thefollowing table summarizes the Company’s sales growth by market. The table andfollowing discussion is on a comparable basis, which excludes the effects ofcurrency fluctuations.

| ** **                   | ** ** | **Americas** | ** ** | **Asia-Pacific** | ** ** | **Europe** | ** ** | **Total** | ** ** |
|------------------------------|------------|--------------|------------|------------------|------------|------------|------------|-----------|------------|
| Agriculture/Turf  Care       |       |         | 5          | %                |       |       | (26        | )%        |       |   | 8 | % |   |   | 5 | % |   |
| Construction/Road  Building  |       |         | 6          |             |       |       | 17         |      |       |   | 20 |   |   |   | 14 |   |   |
| Material  Handling/Specialty |       |         | 22         |             |       |       | 32         |      |       |   | 14 |   |   |   | 17 |   |   |
| Distribution                 |       |         | 18         |             |       |       | 21         |      |       |   | 8 |   |   |   | 15 |   |   |

 

***Agriculture/Turf Care***

The turf care market inthe U.S. was moderately strong through the first half of the year but declinedduring the last half of the year. The strengthening agriculture market inBrazil and the increasing commodity prices in the U.S. contributed to theincreased sales in the agricultural market in the Americas. Sales in theEuropean market increased slightly compared to 2005 due primarily tostrengthening economic conditions, particularly in Germany. The Asia-Pacificregion contributes less than 5 percent of the sales in the agriculture andturf care markets and therefore the decrease in the Asia-Pacific region doesnot significantly impact the total market.

***Construction/Road Building***

All regions experiencedsales increases in the construction and road building markets during 2006.Europe experienced the strongest growth at 20 percent. Increases in Europeare attributable to strengthening of the overall economy and strong exportmarkets. The 6 percent increase in sales in the Americas region isprimarily driven by strengthening economic conditions in Brazil as well asincreased production of skid steer loaders and crawlers, particularly duringthe first half of the year. The Asia-Pacific market also benefited from thegrowth in the skid steer loader market, in addition to increased demand fromthe Chinese transit mixer market. The road building market in the Asia-Pacificregion showed strong increases, mainly due to China’s increased focus oninfrastructure spending.

20

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***Material Handling/Specialty***

Specialty vehicles arecomprised of a variety of markets including forestry, material handling, marine,waste management and waste recycling. All regions contributed to the salesgrowth in the specialty markets. Growth in the aerial lift market continues tobe the main contributor to the overall 17 percent increase in sales in2006.

***Distribution***

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

***OrderBacklog***

Thefollowing table shows the Company’s order backlog and orders written activityfor 2005 and 2006, separately identifying the impact of currency fluctuations.

| **(in millions)**       | ** ** | ** ** | ** ** | **2005** | ** ** | **Currency  Fluctuation** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2006**   | ** ** |
|------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|--------------------------------------|------------|------------|------------|
| **Total**                    | ** ** | ** ** | ** ** |     | ** ** | ** **                |       |                                 | ** ** | ** ** |       | ** ** | ** ** |
| Backlog at  December 31 |       | $          | 504.2      |     |       | $                         | 32.8       | ** **                           |       |       | $          | 95.4 | ** ** |   | $ | 632.4 |   |
| Orders written               |       | 1,631.7    |       |     | 8.8        | ** **                |       |                                 | 244.4      | ** ** |       | 1,884.9 |   |
|                              |            |            |            |          |            |                           |            |                                      |            |            |            |  |  |  |  |  |  |  |  |

 

Total order backlog at the end of 2006 was$632.4 million, compared to $504.2 million at the end of 2005. On acomparable basis, excluding the impact of currency fluctuation, order backlogincreased 19 percent over 2005. New sales orders written for 2006 were $1,884.9 million,an increase of 15 percent over 2005, excluding the impact of currencyfluctuations.

In recent years backloginformation has become less reliable as an indicator of future sales levels ascustomers alter their sales order patterns. The 15 percent increase inorders written in 2006 is reflective of the strong sales experienced during theyear and backlog remains strong at the end of the year with over$630 million of customer orders received for future delivery.

***Business Segment Results***

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 taxes, minority interest, and global service expenses.Propel products include hydrostatic transmissions and related products thattransmit the power from the engine to the wheel to propel a vehicle. WorkFunction products include steering motors as well as gear pumps and motors thattransmit power for the work functions of the vehicle. Controls products includeelectrohydraulic controls, microprocessors, electric drives and valves thatcontrol and direct the power of a vehicle.

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Thefollowing table provides a summary of each segment’s net sales and segmentincome, separately identifying the impact of currency fluctuations during theyear.

| **(in millions)**                   | ** ** | ** ** | ** ** | **2005** | ** ** | **Currency  fluctuation** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2006**   | ** ** |
|------------------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|--------------------------------------|------------|------------|------------|
| **Net sales**                            | ** ** | ** ** | ** ** |     | ** ** | ** **                |       |                                 | ** ** | ** ** |       | ** ** | ** ** |
| Propel                                   |       | $          | 751.1      |     |       | $                         | 1.0        |                                 |       |       | $          | 87.2 |   |   | $ | 839.3 |   |
| Work Function                            |       | 430.7      |       |     | 3.3        |                      |       |                                 | 37.4       |       |       | 471.4 |   |
| Controls                                 |       | 366.0      |       |     | 3.6        |                      |       |                                 | 58.8       |       |       | 428.4 |   |
| **Segment  income (loss)**               | ** ** | ** ** | ** ** |     | ** ** | ** **                |       |                                 | ** ** | ** ** |       | ** ** | ** ** |
| Propel                                   |       | $          | 106.4      |     |       | $                         | 0.0        |                                 |       |       | $          | 5.4 |   |   | $ | 111.8 |   |
| Work Function                            |       | 6.3        |       |     | 0.3        |                      |       |                                 | 9.9        |       |       | 16.5 |   |
| Controls                                 |       | 31.4       |       |     | 0.1        |                      |       |                                 | 11.2       |       |       | 42.7 |   |
| Global Services  and other expenses, net |       | (60.1      | )          |     | (0.2       | )                         |       |                                 | (0.3       | )          |       | (60.6 | ) |

 

***Propel Segment***

The Propel segmentexperienced strong growth in 2006, with a sales increase of 12 percentexcluding the effects of currency fluctuations. Gross profit margin decreased 1.2 percent excluding the effects ofcurrency fluctuations during 2006. The decrease in gross profit margin isprimarily due to $8.3 million of restructuring charges. In March 2006the Company announced plans to close the manufacturing facility in LaSalle,Illinois during 2006 along with certain other restructuring activities.Restructuring costs incurred in 2006 consist of employee termination costs of$1.6 million, pension curtailment charges of $1.6 million,accelerated depreciation of fixed assets of $2.1 million, and$3.0 million of other charges.

***Work Function Segment***

Sales in the Work Functionsegment increased 9 percent, excluding the effects of currencyfluctuations during 2006. The gross profit margin increased 0.7 percentexcluding the impacts of currency fluctuations during 2006. Segment income wasnegatively impacted by $3.5 million of restructuring costs. In March 2006the Company announced plans to discontinue production of certain product linesmanufactured in the Swindon, England plant resulting in recognizing$1.9 million of employee termination costs and $1.6 million of fixedasset impairment charges.

***Controls Segment***

Net sales in the Controlssegment, excluding the effects of currency fluctuations, increased16 percent during 2006. The gross profit margin decreased0.5 percent, excluding the impact of currency fluctuations, with increasesthrough September 2006 offset by declines in the fourth quarter due tocosts incurred for the introduction of new products. Despite increased sales,operating costs were $0.2 million lower primarily due to higher costs in2005 for research and development spending for new products in the developmentstage as well as start-up costs related to a new production facility in India.The increase in sales, nearly flat margins and decreases in operating costscontributed to a 36 percent increase in segment income.

***Global Services and otherexpenses, net***

Segment costs in GlobalServices and other expenses, net relate to internal global service departments,along with the operating costs of the Company’s executive offices. Globalservices include costs such as consulting for special projects, tax, andaccounting fees paid to outside third parties, certain insurance premiums, andthe amortization of intangible assets from certain business combinations. Global Services 

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costs decreased $0.3 million in 2006 comparedto the same period in 2005, excluding the effects of currency fluctuations. TheCompany incurred $5.8 million of losses on foreign currency transactionsin 2006 compared to $3.2 million of gains on foreign currency transactionsin 2005, which negatively affected other expenses by $9.0 million whencomparing to the 2005 results. These increases were offset by a$3.4 million decrease in costs associated with the implementation of acommon company wide business system, decreased long-term incentive plan costsof $2.7 million, and a decrease of $3.4 million in outside servicecosts related to the assessment of internal controls under Section 404 ofthe Sarbanes-Oxley Act of 2002.

***IncomeTaxes***

The Company’s effective tax rate was 24.3 percentin 2006 compared to 22.1 percent in 2005.

The 2006 rate includesbenefit of $5.7 million for reversal of valuation allowances on deferredtax assets. The 2005 rate also included benefit of $4.4 million forreversal of valuation allowances on deferred tax assets. These deferred taxassets were generated in prior years and no tax benefits were recognized atthat time. In addition, the2005 rate included the benefit of the reduction of the statutory tax rate inDenmark from 30 percent to 28 percent, enacted in 2005, that resultedin a tax benefit of $1.5 million.

**Executive Summaryof 2005 Compared to 2004**

Thefollowing table summarizes the change in the Company’s results from operationsby separately identifying changes due to currency fluctuations and theunderlying 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. Theimproving economy in the U.S., not only resulted in increased sales within theAmericas, 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.

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The increase in selling,general, and administrative costs in 2005 was due to the continuing developmentand implementation of a common business system to standardize businessprocesses and provide a single interface to direct OEM customers and suppliers.The new business system has been in development since 2003 and the costsincurred in 2004, with the exception of $3.5 million, related todevelopment and therefore were capitalized. The common business system wasimplemented at five locations during 2005 and costs related to the system andits implementation are now expensed. Costs in 2005 related to the commonbusiness system totaled $23.0 million, of which $5.8 million are ofan ongoing nature that will replace costs related to the current systems inplace. In future years it is anticipated that the investment in the commonbusiness system will drive improved operational efficiency, customer service,and thereby improve financial performance. The system will continue to beimplemented at additional locations until complete in 2008. The Companyincurred $4.4 million of expense in 2004 to restructure its sales anddistribution operations in Europe resulting in consolidated inventory,warehouse, and distribution operations as well as streamlined delivery directlyfrom the manufacturing locations to the customer. There were no additionalcosts related to this restructuring in 2005.

Research and developmentcosts increased approximately 13 percent in 2005, due to ongoing researchprojects, primarily related to the Propel and Controls segments.

In 2005 the Companyrecognized other income of $3.2 million related to foreign currency gainson transactions. The Company recognized $4.1 million of expense in 2004due to foreign currency losses on transactions. This fluctuation between yearswas primarily due to the significant weakening of the U.S. dollar in late 2004and the strengthening of the U.S. dollar throughout 2005.

**Operating Results — 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 |   |   |
| Material  Handling/Specialty |       |         | 30         |             |       |       | 5          |      |       |   | 11 |   |   |   | 14 |   |   |
| Distribution                 |       |         | 14         |             |       |       | 2          |      |       |   | 7 |   |   |   | 10 |   |   |

 

***Agriculture/Turf Care***

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.

***Construction/Road Building***

The construction and roadbuilding markets were improved in the Americas in 2005. The 20 percentgrowth in the Americas is primarily due to a strong market for skid steerloaders; however, sales also increased due to new sales of medium powerhydrostatic products to a major OEM in 2005. The 29 percent growth inAsia-Pacific is also due to strong markets for skid steer loaders and roadroller products in North America as the OEMs are exporting product to theAmericas. The transit mixer market drove the growth in the European market in2005, in addition to OEMs exporting product to the Americas for the roadbuilding market.

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***Material Handling/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 theEuropean specialty markets. The sales growth in the Asia-Pacific region is dueto increased sales into the mining market, although Asia-Pacific sales are asmall percentage of the Company’s total sales in the specialty markets.

***Distribution***

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

***OrderBacklog***

Thefollowing table shows the Company’s order backlog and orders written activityfor 2004 and 2005, separately identifying the impact of currency fluctuations.Order backlog represents the amount of customer orders received for futureshipment.

| **(in millions)**       | ** ** | ** ** | ** ** | **2004** | ** ** | **Currency  Fluctuation** | ** ** | **Underlying  increase  (decrease)** | ** ** | **2005**   | ** ** |
|------------------------------|------------|------------|------------|----------|------------|---------------------------|------------|--------------------------------------|------------|------------|------------|
| **Total**                    | ** ** | ** ** | ** ** |     | ** ** | ** **                |       |                                 | ** ** | ** ** |       | ** ** | ** ** |
| Backlog at  December 31 |       | $          | 467.4      |     |       | $                         | (22.0      | )                                    |       |       | $          | 58.8 | ** ** |   | $ | 504.2 |   |
| Orders written               |       | 1,429.4    |       |     | 3.6        |                      |       |                                 | 198.7      | ** ** |       | 1,631.7 |   |
|                              |            |            |            |          |            |                           |            |                                      |            |            |            |  |  |  |  |  |  |  |  |

 

Total order backlog at theend of 2005 was $504.2 million, compared to $467.4 million at the endof 2004. On a comparable basis, excluding the impact of currency fluctuation,order backlog increased 13 percent over 2004. New sales orders written for2005 were $1,631.7 million, an increase of 14 percent over 2004,excluding the impact of currency fluctuations.

In recent years backloginformation has become less reliable as an indicator of future sales levels ascustomers alter their sales order patterns. The 14 percent increase inorders written in 2005 is reflective of the strong sales experienced during theyear and backlog remains strong at the end of the year with over$500 million of customers orders received for future delivery.

***Business Segment Results***

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 | ) |

 

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***Propel Segment***

*The Propelsegment experienced the strongest growth in 2005, with a sales increase of14 percent excluding the effects of currency fluctuations. Consumerscontinue to move away from mechanical transmissions to hydrostatictransmissions in the turf care market, which has contributed to increased salesin the Propel segment, although, as noted in the market section, the growth inthe turf care market is beginning to level off. The gross profit percentage ofsales in the Propel segment was consistent in 2005 with the 25 percentachieved in 2004. Segment income increased 18 percent from 2004, excludingthe effects of currency fluctuations.*

***Work Function Segment***

*Sales inthe Work Function segment increased by 4 percent, excluding the effect ofcurrency fluctuations, in 2005 compared to 2004. Similar to 2004, demand forWork Function product has been high and has resulted in increased overtimecosts and increased delivery costs to expedite shipments to meet customerdemand which has had a negative impact on the gross margin. In late 2005 theCompany established production capacity in the U.S. for Work Function productsthat are sold in the U.S. market. This additional production capability isexpected to reduce capacity constraints and freight costs in 2006. During 2005the Work Function segment recognized $1.0 million of field recall costsrelated to two separate quality issues. In 2004 the income of the Work Functionsegment was negatively affected by $2.2 million of restructuring costs,including the remaining costs to relocate the operations of the Company’s WestBranch, Iowa facility that was started in 2003.*

***Controls Segment***

*Netsales increased 8 percent, excluding the effects of currency fluctuations,in 2005 compared to 2004. Gross profit as a percent of sales was consistentwith 2004 at 28 percent. Segment income in 2005 increased 26 percentcompared to 2004 excluding the impact of currency fluctuations.*

***Global Services and otherexpenses, net***

Expenses in globalservices increased in 2005 due to $19.5 million of increased expensesrelated to the common business system. This increased expense was partiallyoff-set by a $7.3 million fluctuation in foreign currency gain/loss and a$1.5 million reduction in outside service costs to assess internalcontrols and related audit costs to test management’s assessment of internalcontrol under Section 404 of the Sarbanes-Oxley Act of 2002. Total costsin 2005 related to the internal control assessment were $5.2 million in2005, compared to $6.7 million in 2004. As noted in the executive summary,the Company recognized other income of $3.2 million related to foreigncurrency gains on transactions in 2005 compared to $4.1 million of losseson foreign currency exchange in 2004, which is included in global services and otherexpenses.

***IncomeTaxes***

The Company’s effective tax rate was 22.1 percentin 2005 compared to 32.2 percent in 2004.

The 2005 rate includes thebenefit of the reduction of the statutory tax rate in Denmark from30 percent to 28 percent that was enacted in 2005. This change in taxrate resulted in a decrease of tax expense of $0.4 million for currentyear income and $1.1 million for the change in deferred tax liabilitiesrelated to earlier periods for a total benefit of $1.5 million. Thebenefit was partially offset by $0.8 million of tax expense in the U.S.related to the repatriation of previously undistributed earnings from asubsidiary in Denmark, in connection with the American Jobs Creation Act. The2005 rate also includes benefit of $4.4 million for reversal of valuationallowances on deferred tax assets. These deferred tax assets were generated inprior years and no tax benefits were recognized at that time.

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**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 operationsand sells its products in many different countries of the world and therefore,conducts its business in various currencies. The Company’s financialstatements, which are presented in U.S. dollars, can be impacted by foreignexchange fluctuations through both translation risk and transaction risk.Translation risk is the risk that the financial statements of the Company, fora particular period or as of a certain date, may be affected by changes in theexchange rates that are used to translate the financial statements of theCompany’s operations from foreign currencies into U.S. dollars. Transactionrisk is the risk from the Company receiving its sale proceeds or holding itsassets in a currency different from that in which it pays its expenses andholds its liabilities.

In previous years, theCompany had been well balanced between its U.S. and European operations becausethe Company generated its sales in the same country in which it incurred itsexpenses, or shipped products between geographic regions on a balanced basis.However, in recent years the balance has shifted and the amount of sales madein U.S. dollars has increased, whereas the production costs are in a currencyother than the U.S. dollar, increasing the Company’s exposure to transactionrisk. In 2006 the Company sold a total of $159.7 million into the U.S. ofproduct that had been produced in European based currencies compared to salesinto Europe of $57.6 million of product produced in U.S. dollars. Thisimbalance had a significant impact on the results of the Company. In 2006 theresults were unfavorable as the dollar weakened in comparison to othercurrencies compared to 2005. The Company produces and sells its product inseveral regions of the world, however the U.S. and European transactionscomprise the majority of the imbalance between regions.

In 2005 the Company beganto enter into forward contracts to minimize the impact of currency fluctuationson cash flows related to forecasted sales denominated in currencies other thanthe functional currency of the selling location. The forecasted sales representsales to both external and internal parties. Any effects of the forwardcontracts related to sales to internal parties are eliminated in theconsolidation process until the related inventory has been sold to an externalparty. The forward contracts qualify for hedge accounting and therefore aresubject to effectiveness testing at the inception of the contract andthroughout the life of the contract. In 2006 as a result of hedge accountingfor the forward contracts, the Company recognized an increase to net sales of$0.5 million and expense of $0.3 million was recorded to offset gainon currency transactions. The fair value of forward contracts included as anasset on the balance sheet at December 31, 2006 was $1.1 million.

The Company is alsoimpacted by translation risk in terms of comparing results from period toperiod. Fluctuations of currencies against the U.S. dollar can be substantialand therefore, significantly impact comparisons with prior periods. Thetranslation impact on making prior period comparisons with respect to theCompany’s net sales can be material, although the impact has not been significantin either 2006 or 2005. Translation affects the comparability of both theincome statement and the balance sheet.

The change in the exchangerate does affect the comparability of the balance sheet between 2006 and 2005as the balance sheet accounts are translated at the exchange rate as of December 31.The U.S. dollar weakened by 11 percent against the euro and the Danishkroner from December 31, 2005 to December 31, 2006. The weakening ofthe dollar has resulted in approximately 40 percent of the Company’s totalbalance sheet being stated 11 percent higher than the prior year sinceroughly 40 percent of the Company’s total assets and liabilities aredenominated in the euro or the Danish kroner.

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***Interest Rate Changes***

The Company uses interestrate swap agreements on a limited basis to manage the interest rate risk on thetotal debt portfolio. The Company was a party to three interest rate swapagreements at December 31, 2006, with a combined notional amount of4.7 million euro, that require the Company to pay interest at a fixed rateand receive interest at a variable rate. The fair value of the interest rateswap agreements is recorded as a liability of $0.1 million on the balancesheet at December 31, 2006, with the offset recorded in accumulated othercomprehensive income as the derivatives are accounted for using hedgeaccounting. The interest rate swap agreements 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** | ** ** |
|----------------------|------------|------------------------------------|------------|------------------------------|------------|
| 2007                 |       |                               | $          | 7.5                          |       |   |   | $ | 112.7 |   |   |
| 2008                 |       |                               | 14.6       |                         |       |   | — |   |   |
| 2009                 |       |                               | 13.3       |                         |       |   | — |   |   |
| 2010                 |       |                               | 15.2       |                         |       |   | 5.2 |   |   |
| 2011                 |       |                               | 18.1       |                         |       |   | 10.4 |   |   |
| 2012 and  Thereafter |       |                               | 69.1       |                         |       |   | 36.5 |   |   |
| Total                |       |                               | $          | 137.8                        |       |   |   | $ | 164.8 |   |   |

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(1)          Includestotal principal repayments of $6.2 million on variable rate debt. The ratehas been fixed through the use of interest rate swaps.

**Liquidity and Capital Resources**

The Company’s principalsources of liquidity have been cash flow from operations and from its variouscredit facilities. The Company historically has accessed diverse fundingsources, including short and long-term unsecured bank lines of credit in theUnited States, Europe, and Asia, as well as the private debt markets in theUnited States as discussed in Note 7 in the Notes to ConsolidatedFinancial Statements. The Company expects to have sufficient sources ofliquidity to meet its future funding needs due to the multiple funding sourcesthat have been, and continue to be, available to the Company.

The multicurrencyrevolving credit facility, as modified in July 2006, provides up to$300 million of unsecured credit through December 2010, as well as40 million euro term loan which expires in July 2013. AtDecember 31, 2006 the Company had $106.4 million outstanding underthe revolving credit facility. The Company is required to meet certainfinancial covenants under this facility as described in Note 7 in theNotes to Consolidated Financial Statements. The Company was in compliance withthe covenants at December 31, 2006 and is not aware of any circumstancescurrently that would impact compliance during the next twelve months.

***Cash Flows from Operations***

Cash provided byoperations was $167.9 million in 2006. The Company invested an additional$14.3 million, excluding the effect of currency, in inventories in 2006 inorder to meet the anticipated increase in demand for product in early 2007. Inaddition, a large increase in receivables of $24.5 million contributed toa use of cash due to the higher level of sales in the fourth quarter. Theseincreases were offset by an increase in accounts payable of $27.2 million,primarily due to the increase in inventory.

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Total cash of the Companyincreased $14.9 million from December 31, 2005 to December 31,2006. At December 31, 2006 cash balances in China totaled$23.0 million, an increase of $12.5 million from December 31,2005. The Company is paying dividends from its Chinese entities to the maximumextent possible under current regulations, however, due to the nature of thegovernmental and other regulatory controls, it is difficult to move cash out ofChina for reasons other than payment for goods shipped into that country. Asthe Company continues to consider expanding its manufacturing capabilities inlow cost regions, it will make every effort to utilize the cash balances inthose regions to fund future expansions. Total cash outside of China increasedby $2.4 million in 2006.

***Cash Used in Investing Activities***

Capital expenditures for2006 totaled $116.2 million. Capital expenditures were high in allbusiness segments and were primarily related to the addition of productioncapacity in order to meet anticipated future demand levels.

***Cash Used in Financing Activities***

The Company continues topay dividends to stockholders on a quarterly basis with $26.7 million ofcash used to pay dividends in 2006. In addition, the Company periodically makesdistributions to its minority interest partners from its various joint ventureactivities with distributions totaling $19.9 million in 2006. Thedistributions can vary from year to year depending on the amount ofundistributed earnings of the businesses and the needs of the partners. TheCompany borrowed an additional $1.8 million, net, in 2006, and paid$0.3 million of fees related to the modification of its multicurrencyrevolving credit facility discussed above in Liquidity and Capital Resources.

***Contractual Cash Obligations***

The majorityof the Company’s contractual obligations to make cash payments to third partiesare for financing obligations. These include future lease payments under bothoperating and capital leases. The following table discloses the Company’sfuture commitments under contractual obligations as of December 31, 2006:

| ** **                                                        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **2012 and** | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|-------------------|------------|
| **Contractual Cash Obligations (3)**               | ** ** | ** ** | ** ** | **Total**  | ** ** | **2007**   | ** ** | **2008**   | ** ** | **2009**   | ** ** | **2010**   | ** ** | **2011**          | ** ** | **Thereafter** | ** ** |
| Long-term debt                                                    |       | $          | 302,631    |       | $          | 120,243    |       | $          | 14,554     |       | $          | 13,292     |       | $                 | 20,360     |   | $ | 28,513 |   | $ | 105,669 |   |
| Interest on  long-term debt (1),(2)                               |       | 63,192     |       | 14,609     |       | 13,642     |       | 12,397     |       | 11,105     |       | 3,922      |       | 7,517             |       |
| Capital leases                                                    |       | 19,076     |       | 1,131      |       | 1,139      |       | 1,129      |       | 999        |       | 876        |       | 13,802            |       |
| Operating leases                                                  |       | 54,389     |       | 10,956     |       | 8,819      |       | 6,730      |       | 3,517      |       | 1,496      |       | 22,871            |       |
| Rental and  service agreemnts with related party Danfoss A/S |       | 54,959     |       | 7,583      |       | 7,582      |       | 7,580      |       | 7,588      |       | 7,597      |       | 17,029            |       |
| Total contractual cash  obligations                               |       | $          | 494,247    |       | $          | 154,522    |       | $          | 45,736     |       | $          | 41,128     |       | $                 | 43,569     |   | $ | 42,404 |   | $ | 166,888 |   |
|                                                                   |            |            |            |            |            |            |            |            |            |            |            |            |            |                   |            |  |  |  |  |  |  |  |  |  |

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Thefollowing assumptions are used in the calculation of the contractual cashobligations:

(1)         Theannual amount borrowed under revolving credit agreements does not change fromthe $106.4 million borrowed at December 31, 2006, through thematurity date of the agreements.

(2)         Themargin rate on variable interest rate debt does not change from December 31,2006. The base interest rate for future years is based on the interest yieldcurves as of December 31, 2006.

(3)         Commitmentsdenominated in a currency other than the U.S. dollar are translated at the December 31,2006 exchange rate.

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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 2007the Company anticipates contributing $6.1 million to its U.S. and U.K.pension and health benefit plans. Although the Company has not funded theGerman pension plan in the past, it is discussing funding options and maypartially fund the pension liabilities in 2007.

**Other Matters**

***Critical Accounting Estimates***

The SEC’s guidancesurrounding the disclosure of critical accounting estimates requiresdisclosures about estimates a company makes in applying its accountingpolicies. However, such discussion is limited to “critical accountingestimates,” or those that management believes meet two criteria: 1) theaccounting estimate must require a company to make assumptions about mattersthat are highly uncertain at the time the accounting estimate is made, and2) different estimates that the company reasonably could have used for theaccounting estimate in the current period, or changes in the accountingestimate that are reasonably likely to occur from period to period could have amaterial impact on the presentation of the company’s financial condition,changes in financial condition or results of operations.

Besides the estimates thatmeet the two criteria for a “critical estimate” above, the Company makes manyother accounting estimates in preparing its financial statements and relateddisclosures. All estimates, whether or not deemed critical, can affect thereported amounts of assets, liabilities, revenues, and expenses as well asdisclosures of contingent assets and liabilities. Estimates are based onexperience and information available prior to the issuance of the financialstatements. Materially different results can occur as circumstances change andadditional information becomes known, including estimates not deemed “critical”under the SEC’s guidance.

The discussion belowshould be read in conjunction with disclosures elsewhere in this discussion andin the Notes to the Consolidated Financial Statements related to estimates,uncertainties, contingencies, and new accounting standards. Significantaccounting policies are discussed in Note 1 to the Consolidated FinancialStatements beginning on page F-5. The development and selection ofaccounting estimates, including those deemed “critical,” and the associateddisclosures in this discussion, have been discussed by management with theaudit committee of the Board of Directors.

*InventoryValuation *— As a manufacturer in the capital goodsindustry, inventory is a substantial portion of the assets of the Company,amounting to over 20 percent of total assets at December 31, 2006.The Company must periodically evaluate the carrying value of its inventory toassess the proper valuation. This includes recording period adjustments asneeded to 1) record expenses due to excess capacity, 2) provide forexcess and obsolete inventory, and 3) ensure that inventory is valued atthe lower of cost or market. On a quarterly basis, management within eachsegment performs an analysis of the underlying inventory to identify the needfor appropriate write-downs to cover each of these items. In doing so,management applies consistent practices based upon historical data such asactual loss experience, past and projected usage, actual margins generated fromtrade sales of its products, and finally its best judgment to estimate theappropriate carrying value of the inventory.

*Warranty Provisions* —The Company warrants its various products over differing periods depending uponthe type of product and application. Consequently, the Company recordsliabilities for the estimated warranty costs that may be incurred under itsbasic warranty based on past trends of actual warranty claims compared to theactual sales levels to which those claims apply. These liabilities are accruedat the time the sales of the products are recorded. Factors that affect theCompany’s warranty liability include the number of units in the field currentlyunder warranty, historical and anticipated rates of warranty claims on thoseunits and the cost per claim to satisfy the Company’s warranty obligation. Theanticipated rate of warranty 

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claimsis the primary factor impacting the Company’s estimated warranty obligation.Each quarter, the Company reevaluates its estimates to assess the adequacy ofits recorded 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 recalls”and in these instances, the Company will record 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. Typically, field recalls are infrequent in occurrence,however, when they occur, field recalls can be for a large number of units andquite costly to rectify. Because of the sporadic and infrequent nature of fieldrecalls, and due to the extreme 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 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 the Company’stotal assets consist of property, plant and equipment (PP&E) and definitelife intangibles, as well as goodwill. Changes in technology or in the Company’sintended use of these assets, as well as changes in the broad global economy inwhich the Company operates, may cause the estimated period of use or thecarrying value of these assets to change.

This requires the Companyto periodically assess the estimated useful lives of its assets in order tomatch, through depreciation and amortization, the cost of those assets with thebenefits derived over the period of usefulness. The useful lives of these assetscan be shortened through greater use due to volume increases, rapidly changingtechnology such as the use of electronics and computer-operated controls, andthrough inadequate maintenance. Despite management’s best efforts to determinethe appropriate useful lives of its equipment, certain situations may arisethat lead to an asset or group of assets becoming impaired, meaning theireconomic value becomes less than the value at which the Company is carrying theasset on its books. Examples of these situations are product rationalizationefforts or restructuring of manufacturing facilities. When these situationsarise, the Company tests the assets for impairment and will write down theasset in the period when the impairment becomes known. In addition, goodwill istested for impairment at least annually. As of December 31, 2006 a tenpercent change in the depreciable lives of the Company’s assets would impactdepreciation expense by approximately $9.6 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 insurance policy tocover workers compensation claims in the United States, in which the Companypays the first $0.25 million per claim, per incident. The Companyestablishes its workers compensation reserve based on historic growth factorsof claims and an estimate of incurred, but not reported claims. This analysisis performed on a quarterly basis.

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*U.S. Health Care Costs* — TheCompany self insures its U.S. health care costs for eligible employees andtheir qualified dependents with exposure for any one year, excludingprescription costs, limited to $0.2 million per individual. The Companyestablishes reserves for its health care cost based on historic claims data andan estimate of incurred, but not reported claims. This analysis is performed ona quarterly basis.

*Pensions *—The Company has noncontributory defined benefit pension plans for a portion ofits employees. In certain countries, such as the United States and the UnitedKingdom, these plans are funded with plan assets whereas in other countriessuch as Germany, the plans are completely unfunded, which is customary. Themeasurement of the Company’s pension obligations and costs is dependent on avariety of assumptions determined by management and used by the Company’sactuaries. These assumptions include estimates of the present value ofprojected future pension payments to all plan participants, taking intoconsideration the likelihood of potential future events such as salaryincreases and other experience. These assumptions may have an effect on theamount and timing of future contributions. The plan trustee conducts anindependent valuation of the fair value of pension plan assets.

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 thediscount rate assumption on investment yields available at or near year-end oncorporate long-term bonds rated AA. The inflation assumption is based on an evaluationof external market indicators. The salary growth assumptions reflect theCompany’s long-term actual experience, the near-term outlook and assumedinflation. The expected return on plan assets reflects asset allocations,investment strategy, and the views of investment managers and other largepension plan sponsors. Retirement and mortality rates are based primarily onactual plan experience and standard industry actuarial tables, respectively.The effects of actual results differing from our assumptions are accumulatedand amortized over future periods and, therefore, generally affect recognizedexpense in such future periods.

The Company’s fundingpolicy for the U.S. plans are 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. In2007 the Company anticipates contributing $2.2 million to its U.S. plansand $1.3 million to its U.K. plans.

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

The postretirementliability, which is determined on an actuarial basis, is recognized in theCompany’s Consolidated Balance Sheets and the postretirement expense isrecognized in the Consolidated Statements of Income. The Company must determinethe actuarial assumption for the discount rate used to reflect the time valueof money in the calculation of the accumulated postretirement benefitobligation for the end of the current year and to determine the postretirementcost for the subsequent year. For guidance in determining this rate, theCompany looks at investment yield trends available near year-end on corporatebonds rated AA. In addition, the Company must determine the actuarialassumption for the health care cost trend rate used in the calculation of theaccumulated postretirement benefit obligation for the end of the current yearand to determine the net periodic postretirement benefit cost for the subsequentyear. As 

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of December 31,2006 a one-percentage-point change in the assumed health care cost trend ratewould impact the expense recognized in 2006 by $0.2 million and wouldaffect the post-retirement benefit obligation by $2.4 million. In2007 the Company anticipates contributing $2.6 million to this plan.

*DeferredIncome Taxes* — Tax regulations may require items to beincluded in the tax return at different times than the items are reflected inthe financial statements. Some of the differences are permanent, such asexpenses that are not deductible on a tax return, and some of the differencesare temporary such as depreciation expense. Temporary differences createdeferred tax assets and liabilities. Deferred tax assets generally areattributable to items that can be used as a tax deduction or credit in a taxreturn in future years but the amount has already been included as an expensein the financial statements. Deferred tax liabilities generally representdeductions that have been taken on the tax return but have not been recognizedas expense in the financial statements. Valuation allowances are recorded toreduce deferred tax assets when it is more likely than not that a tax benefitwill not be realized.

***New Accounting Policies***

In November 2004 theFinancial Accounting Standards Board (FASB) issued SFAS No. 151, “InventoryCosts.” SFAS No. 151 amends Accounting Research Bulletin No. 43,Chapter 4 on inventory pricing to clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted materials should berecognized as current period charges. In addition, SFAS No. 151 requiresthat allocation of fixed production overhead to the costs of conversion bebased on the normal capacity of the production facilities. The Company adoptedSFAS No. 151 in 2006 with no material effect on the Company’s consolidatedfinancial statements.

In September 2006 theFASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans an amendment of SFAS No. 87, 88,106, and 132(R)”. This standard requires employers to recognize the underfundedor overfunded status of a defined benefit postretirement plan as an asset orliability in its balance sheet and to recognize changes in the funded status inthe year in which the changes occur through accumulated other comprehensiveincome. Additionally, SFAS No. 158 requires employers to measure thefunded status of a plan as of the date of its fiscal year-end. The Companyadopted SFAS No. 158 in 2006. The effect of adoption was to decreaseassets by $1.4 million, increase liabilities by $27.9 million, anddecrease accumulated other comprehensive income by $29.3 million. The newmeasurement date requirement applies for fiscal years ending after December 15,2008, however the Company already uses a measurement date of December 31so this change will have no impact on the consolidated financial statements.

In September 2006 theU.S. Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108(“SAB 108”), “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements.” SAB 108requires quantification of financial statement misstatements based on theeffects of the misstatements on each of the company’s financial statements andthe related financial statement disclosures. The Company adopted SAB 108in 2006 with no impact on the consolidated financial statements.

In June 2006 the FASBissued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109” (FIN 48),which prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. The Company does not expect the adoptionof FIN 48 to have a material impact on financial reporting and iscurrently evaluating the impact, if any, the adoption of FIN 48 will haveon the consolidated financial statements.

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In June 2006 the FASBratified Emerging Issues Task Force (“EITF”) Issue No. 06 — 3, “HowTaxes Collected from Customers and Remitted to Governmental Authorities ShouldBe Presented in the Income Statement (that is, Gross versus Net Presentation)”,which allows companies to adopt a policy of presenting taxes in the income statementon either a gross or net basis. Taxes within the scope of this EITF wouldinclude taxes that are imposed on a revenue transaction between a seller and acustomer. If such taxes are significant, the accounting policy should bedisclosed as well as the amount of taxes included in the financial statementsif presented on a gross basis. EITF No. 06 — 3 is effective forreporting periods beginning after December 15, 2006. The Company iscurrently assessing the impact, if any, of EITF No. 06 — 03 on its consolidatedfinancial statements.

In September 2006FASB issued SFAS No. 157, “Fair Value Measurements” which clarifies theprinciple that fair value should be based on the assumptions that marketparticipants would use when pricing an asset or liability. Additionally, itestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. The Company has not yet determined the impact thatthe implementation of SFAS No. 157 will have on the consolidated financialstatements. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007.

In February 2007 theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities — Including an Amendment of FASB Statement No. 115.”SFAS No. 159 permits many financial instruments and certain other items tobe measured at fair value at the option of the Company. SFAS No. 159 iseffective for financial statements issued for first fiscal years beginningafter November 15, 2007. The Company does not expect the adoption of SFAS No. 159to have a significant impact on the consolidated financial statements.

***Non-Audit Services of Independent Registered PublicAccounting Firm***

The Company’s IndependentRegistered Public Accounting Firm, KPMG LLP, performed the followingnon-audit services that have been approved by the Audit Committee of the Boardof Directors: international tax planning and compliance services, expatriatetax services for persons not in a financial reporting oversight role, statutoryaudits and related matters, and tax and accounting technical support.

***Outlook***

Management of the Companyanticipates strong sales growth in 2007. This should be led by the strongEuropean and Asia-Pacific markets, with the North American markets stillshowing some growth. The implementation of the Company’s common business systemwill continue, with implementation at the Company’s Chinese and Italianlocations occurring in the second quarter of 2007, leaving some sales companiesand smaller plants to be implemented later in 2007 and in 2008.

**Item 7A.**                Quantitativeand Qualitative Disclosures about Market Risk.

Certain market risks arediscussed on pages 27-28 of this report, and the other disclosurerequirements are considered either not applicable or not material.

**Item 8.**                        FinancialStatements and Supplementary Data.

The Consolidated FinancialStatements, Report of Management, and Reports of Independent Registered PublicAccounting Firm are presented on pages F-1 through F-40 of thisreport.

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**Item 9A.**                Controlsand Procedures.

***Conclusion Regarding theEffectiveness of Disclosure Controls and Procedures***

At December 31, 2006the Registrant carried out an evaluation under the supervision and with theparticipation of the Registrant’s management, including the Registrant’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of the Registrant’s disclosure controls and procedurespursuant to Exchange Act Rule 13a-14. Based upon that evaluation,the Chief Executive Officer and Chief Financial Officer have concluded that theRegistrant’s disclosure controls and procedures are effective to ensure thatinformation required to be disclosed in the reports that the Registrant filesor submits under the Exchange Act is recorded, processed, summarized, andreported as required and within the time periods specified in the SEC’s rules andforms. There have been no significant changes in the Registrant’s disclosurecontrols or in other factors that could significantly affect these controlssubsequent to the date of this evaluation.

***Management’s Report on InternalControl Over Financial Reporting***

The Registrant’s management is responsible forestablishing and maintaining a system of internal controls over financial reporting,as such term is defined in Exchange Act Rules 13a-15(f) and 15d-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 examinations by an internalaudit function that coordinates its activities with the Company’s IndependentRegistered Public Accounting Firm. There have been no significant changes inthe Registrant’s internal control over financial reporting during the fourthquarter.

Under the supervision and with the participation ofthe Registrant’s management, including the Registrant’s Chief Executive Officerand Chief Financial Officer, the Registrant conducted an evaluation of theeffectiveness of the Registrant’s internal controls over financial reportingbased on the framework in Internal Control — Integrated Framework issuedby the Committee of Sponsoring Organizations of the Treadway Commission (COSO).Based on the Registrant’s evaluation under the framework in Internal Control —Integrated Framework, the Registrant’s management concluded that its internalcontrol over financial reporting was effective as of December 31, 2006.

The Registrant’s management’s assessment of theeffectiveness of its internal control over financial reporting as of December 31,2006 has been audited by KPMG LLP, an independent registered publicaccounting firm, as stated in their report which is presented on pages F-39and F-40.

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**PART III**

**Item 10.**                 Directors.Executive Officers and Corporate Governance

Information regarding directors of the Company is setforth under the section entitled “ELECTION OF DIRECTORS” of the Company’s ProxyStatement for the annual meeting of stockholders to be held June 14, 2007,(the “Proxy Statement”), and is incorporated herein by reference. Informationregarding executive officers of the Company is set forth in Part I of thisreport under the caption “Executive Officers of the Company.” Information regardingthe Company’s code of conduct and code of ethics is set forth under the sectionentitled “GOVERNANCE OF THE COMPANY — Code of Conduct and Code of Ethics”of the Proxy Statement, and is incorporated herein by reference. Informationregarding the Company’s audit committee is set forth under the section entitled“GOVERNANCE OF THE COMPANY — Audit Committee” of the Proxy Statement andis incorporated herein by reference. Copies of the Worldwide Code of Legal andEthical Business Conduct and the Code of Ethics for Chief Executive Officer,Chief Financial Officer, Principal Accounting Officer or Controller and otherSenior Financial Staff are posted on the Company’s website at www.sauer-danfoss.com,and printed 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.

**Item 11.**                 ExecutiveCompensation

Information as to Executive Compensation is set forthunder the section entitled “Executive Compensation” of the Proxy Statement, andis incorporated herein by reference. Information regarding compensation committeeinterlocks is set forth under the section entitled “Compensation CommitteeInterlocks and Insider Participation” of the Proxy Statement, and isincorporated herein by reference. The Company’s compensation committee’s reportis set forth under the section entitled “Compensation Committee Report” of theProxy Statement, and is incorporated herein by reference.

**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management

Information regarding securities authorized forissuance under equity compensation plans is set forth under the sectionentitled “EXECUTIVE COMPENSATION — Equity Compensation” of the ProxyStatement, and is incorporated herein by reference. Information regardingsecurity ownership is set forth under the section entitled “SECURITY OWNERSHIPOF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT” of the Proxy Statement, and isincorporated herein by reference.

**Item 13.**                 CertainRelationships and Related Transactions

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,the Company has entered into several agreements with Danfoss A/S topurchase ongoing operational services from Danfoss A/S. Information regardingthese relationships and agreements, in addition to other related partytransactions, is set forth in Note 14 in the Notes to ConsolidatedFinancial Statements on pages F-31 to F-32 of this report, andis incorporated herein by reference. Additional information regarding relatedparty transactions is set forth under the section entitled “GOVERNANCE OF THECOMPANY — Related Party Transaction” of the Proxy Statement, and isincorporated herein by reference. Information about the independence of the Company’sdirectors is set forth under the section entitled 

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“‘GOVERNANCE OF THECOMPANY’ and ‘GOVERNANCE OF THE COMPANY — Basis for Board Determination ofIndependence of Directors’” of the Proxy Statement, and is incorporated hereinby reference.

**Item 14.**                 PrincipalAccountant Fees and Services

Information regarding accounting services and fees isset forth under the section entitled “RATIFICATON OF APPOINTMENT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM” of the Proxy Statement, and is incorporatedherein by reference.

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**PART IV**

**Item 15.**                 Exhibitsand Financial Statement Schedules.

**(a)**           The following documents are filed as a part of this report.

(1) The followingconsolidated financial statements and related information, included inItem 8, are filed as a separate section of this report:

Consolidated Statements of Income for the years ended December 31,2006, 2005, and 2004, on page F-1.

Consolidated Balance Sheets as of December 31,2006 and 2005, on page F-2.

Consolidated Statements of Stockholders’ Equity andComprehensive Income for the years ended December 31, 2006, 2005, and2004, on page F-3.

Consolidated Statements of Cash Flows for the yearsended December 31, 2006, 2005, and 2004, on page F-4.

Notes to Consolidated Financial Statements, December 31,2006, 2005, and 2004, on pages F-5 through F-35.

Report of Management and Reports of IndependentRegistered Public Accounting Firm, KPMG LLP, on pages F-36 throughF-40.

(2) The followingschedule:

Schedule II, Valuation and Qualifying Accounts,on page F-41.

Report of Independent Registered Public AccountingFirm, KPMG LLP, on Schedule II, on page F-42.

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

(3) Exhibits

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

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| 10.1(c) |   | The form of  Indemnification Agreement entered into between the Company and each of its  directors and certain officers is attached as Exhibit 10.1(c) to  Amendment No. 1 to the Company’s Form S-1 Registration  Statement filed on April 23, 1998, and is incorporated herein by  reference. |
|---------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(d) |   | The Lease  Agreement for the Company’s Osaka, Japan facility is attached 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 as  Exhibit 10.1(e) to the Company’s Form 10-K filed on March 10, 2006, and  is incorporated herein by reference.                                                                                                                 |
| 10.1(f) |   | The Lease  Agreement for the Company’s Minneapolis, Minnesota, facility is attached as  Exhibit 10.1(h) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and  is incorporated herein by reference.                                            |
| 10.1(g) |   | The Lease  Agreement for the Company’s Berching, Germany, facility dated  November 15, 1996, is attached as Exhibit 10.1(g) to the  Company’s Form 10-K filed on March 12, 2003, and is  incorporated herein by reference.                                                                 |
| 10.1(h) |   | The Lease  Agreement for the Company’s Shanghai/Pudong, China, facility is attached as  Exhibit 10.1(j) to Amendment No. 1 to the Company’s  Form S-1 Registration Statement filed on April 23, 1998, and  is incorporated herein by reference.                                            |
| 10.1(i) |   | The Lease  Agreement for the Company’s Odense, Denmark, facility dated November 15,  1996, is attached as Exhibit 10.1(h) to the Company’s Form 10-K  filed on March 12, 2003, and is incorporated herein by reference.                                                                    |
| 10.1(j) |   | The Indenture of  Lease agreement for the Company’s Nordborg, Denmark, facility effective  May 3, 2000, is attached as Exhibit 10.1(ah) to the Company’s  Form 10-K filed on March 30, 2001, and is incorporated herein  by reference.                                                          |
| 10.1(k) |   | The Lease Agreement  for the Company’s Hillsboro, Oregon, facility effective January 19,  2001, is attached as Exhibit 10.1(ai) to the Company’s Form 10-K  filed on March 30, 2001, and is incorporated herein by reference.                                                                   |
| 10.1(l) |   | The Lease  Agreement for the Company’s leased facility in Ames, Iowa, effective  April 1, 2002, is attached as Exhibit 10.1(am) to the Company’s  Form 10-Q filed on May 15, 2002, and is incorporated herein  by reference.                                                                    |
| 10.1(m) |   | The Office Lease  for the Company’s Chicago, Illinois, Executive Office effective June 1,  2002, is attached as Exhibit 10.1(an) to the Company’s Form 10-Q  filed on May 15, 2002, and is incorporated herein by reference.                                                                    |
| 10.1(n) |   | The Executive  Employment Agreement with David J. Anderson dated January 1, 2003, is  attached as Exhibit 10.1(m) to the Company’s Form 10-K  filed on March 12, 2003, and is incorporated herein by reference.                                                                                 |
| 10.1(o) |   | The Executive  Employment Agreement with Karl J. Schmidt dated January 1, 2003, is  attached as Exhibit 10.1(n) to the Company’s Form 10-K filed  on March 12, 2003, and is incorporated herein by reference.                                                                              |

39

----

 

| 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.                                                                                               |
| 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.                                                              |

40

----

 

| 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. |
| 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 Second  Amendment to Sauer-Danfoss Inc. 1998 Long-Term Incentive Plan is  attached as Exhibit 10 to the Company’s Form 8-K filed on  August 24, 2006, and is incorporated herein by reference.                                                                                                                                                                                                                             |
| 10.1(ak) |   | 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(al) |   | 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(ak) 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(am) |   | 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(an) |   | 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.                                                                                                                                                                                            |

41

----

 

| 10.1(ao) |   | 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(ap) |   | 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(aq) |   | 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(ar) |   | 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(as) |   | 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.                                                                                                                                                                                                                                                                                                                                    |
| 10.1(at) |   | 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(au) |   | 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(av) |   | 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(aw) |   | 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(ax) |   | 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(ay) |   | 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                                                                                                                                                                                                                                                                                                                                                   |

42

----

 

| 10.1(az) |   | 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.                                                                                                                            |
|----------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.1(ba) |   | The  Sauer-Danfoss Inc. 2006 Omnibus Incentive Plan is filed as Appendix A to  the Company’s Definitive Proxy Statement filed on April 24, 2006, and is  incorporated herein by reference.                                                                                                                                                                                                    |
| 10.1(bb) |   | Form of  Performance Unit Award Agreement under the Sauer-Danfoss Inc. 2006  Omnibus Incentive Plan (the “2006 Plan”), representing awards of Performance  Units to participants under the 2006 Plan, including all executive officers,  is attached as Exhibit 10.2 to the Company’s Form 8-K filed  on June 7, 2006, and is incorporated herein by reference.      |
| 10.1(bc) |   | Amended and  Restated Credit Agreement dated as of July 28, 2006, by and among  Sauer-Danfoss Inc., the subsidiary borrowers listed therein, the lenders  listed therein, and JPMorgan Chase Bank, N.A., as Administrative Agent and  Collateral Agent, is attached as Exhibit 10 to the Company’s Form 8-K  filed on August 3, 2006, 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 are listed under Item 15(a)(3) above arefiled or incorporated by reference hereunder.

43

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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 12, 2007**

Pursuantto the requirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the dates indicated. Each person signing below also herebyappoints David J. Anderson and Kenneth D. McCuskey, and each of themsingly, his or her lawful attorney-in-fact with full power to execute and fileany and all amendments to this report together with exhibits thereto andgenerally to do all such things as such attorney-in-fact may deem appropriateto enable Sauer-Danfoss Inc. to comply with the provisions of theSecurities 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 12,  2007 |
| David J.  Anderson     |          | Executive Officer                    |       |                 |
| /s/ KARL J.  SCHMIDT        |          | Executive Vice  President and Chief  |       | March 12,  2007 |
| Karl J.  Schmidt       |          | Financial Officer                    |       |                 |
| /s/ KENNETH D.  MCCUSKEY    |          | Vice President  and Chief Accounting |       | March 12,  2007 |
| Kenneth D.  McCuskey   |          | Officer, Secretary                   |       |                 |
| /s/ OLE STEEN  ANDERSEN     |          | Director                             |       | March 12,  2007 |
| Ole  Steen Andersen         |          |                                 |       |                 |
| /s/ JORGEN M.  CLAUSEN      |          | Director                             |       | March 12,  2007 |
| JOrgen M.  Clausen     |          |                                 |       |                 |
| /s/ NICOLA  KEIM            |          | Director                             |       | March 12,  2007 |
| Nicola  Keim                |          |                                 |       |                 |
| /s/ JOHANNES  F. KIRCHOFF   |          | Director                             |       | March 12,  2007 |
| Johannes F.  Kirchhoff |          |                                 |       |                 |
| /s/ HANS KIRK               |          | Director                             |       | March 12,  2007 |
| Hans Kirk                   |          |                                 |       |                 |

44

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| /s/ F. JOSEPH LOUGHREY  |   | Director |   | March 12, 2007  |
|-------------------------|--------|----------|--------|----------------------|
| F. Joseph Loughrey |   |     |   |                 |
| /s/ KLAUS H.  MURMANN   |   | Director |   | March 12,  2007 |
| Klaus H.  Murmann  |   |     |   |                 |
| /s/s SVEN  MURMANN      |   | Director |   | March 12,  2007 |
| Sven  Murmann           |   |     |   |                 |
| /s/ STEVEN H.  WOOD     |   | Director |   | March 12,  2007 |
| Steven H.  Wood    |   |     |   |                 |

 

45

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**Sauer-Danfoss Inc. and SubsidiariesConsolidated Statements of Income(Dollars in thousands, except per share data)**

| ** **                                               | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                               | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Net  Sales**                                           |       | $                                                             | 1,739,088  |   | $ | 1,547,816 |   | $ | 1,404,159 |   |
| **Costs and Expenses:**                                  |       |                                                          |       |   |   |   |   |
| Cost of sales                                            |       | 1,342,324                                                     |       | 1,190,070 |   | 1,058,075 |   |
| Selling, general and administrative                      |       | 215,565                                                       |       | 217,130 |   | 200,142 |   |
| Research and development                                 |       | 61,880                                                        |       | 58,673 |   | 51,913 |   |
| Impairment charges and loss on disposal of fixed  assets |       | 3,246                                                         |       | 1,391 |   | 2,119 |   |
| Total costs and expenses                                 |       | 1,623,015                                                     |       | 1,467,264 |   | 1,312,249 |   |
| Operating income                                         |       | 116,073                                                       |       | 80,552 |   | 91,910 |   |
| **Nonoperating  Income (Expenses):**                     |       |                                                          |       |   |   |   |   |
| Interest expense                                         |       | (18,415                                                       | )          | (17,540 | ) | (18,403 | ) |
| Interest income                                          |       | 654                                                           |       | 1,887 |   | 988 |   |
| Other, net                                               |       | (5,675                                                        | )          | 3,465 |   | (4,052 | ) |
| Nonoperating expenses, net                               |       | (23,436                                                       | )          | (12,188 | ) | (21,467 | ) |
| **Income  Before Income Taxes and Minority Interest**    |       | 92,637                                                        |       | 68,364 |   | 70,443 |   |
| **Minority  Interest**                                   |       | (21,617                                                       | )          | (18,657 | ) | (21,522 | ) |
| **Income  Before Income Taxes**                          |       | 71,020                                                        |       | 49,707 |   | 48,921 |   |
| **Income  Tax Expense**                                  |       | (17,272                                                       | )          | (10,992 | ) | (15,735 | ) |
| **Net Income**                                           |       | $                                                             | 53,748     |   | $ | 38,715 |   | $ | 33,186 |   |
| Net Income per  common share, basic                      |       | $                                                             | 1.13       |   | $ | 0.82 |   | $ | 0.70 |   |
| Net Income per  common share, diluted                    |       | $                                                             | 1.11       |   | $ | 0.81 |   | $ | 0.70 |   |
| Weighted average  basic shares outstanding               |       | 47,699,972                                                    |       | 47,455,507 |   | 47,409,377 |   |
| Weighted average diluted  shares outstanding             |       | 48,237,814                                                    |       | 47,795,160 |   | 47,509,941 |   |

 

See accompanying notes to consolidated financial statements.

F-1

----

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

| ** **                                                                                                                                                | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                |       |                  |       |   |   |
| **Current Assets:**                                                                                                                                       |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                 |       | $                     | 29,112     |   | $ | 14,194 |   |
| Accounts receivable (net of allowances for doubtful  accounts of $5,705 and $4,900 in 2006 and 2005, respectively)                                        |       | 259,976               |       | 220,752 |   |
| Inventories                                                                                                                                               |       | 272,286               |       | 238,905 |   |
| Other current assets                                                                                                                                      |       | 43,931                |       | 38,369 |   |
| Total current assets                                                                                                                                      |       | 605,305               |       | 512,220 |   |
| **Property, Plant and Equipment, net**                                                                                                                    |       | 503,977               |       | 450,426 |   |
| **Other  Assets:**                                                                                                                                        |       |                  |       |   |   |
| Goodwill                                                                                                                                                  |       | 108,811               |       | 120,318 |   |
| Other intangible assets, net                                                                                                                              |       | 27,160                |       | 29,587 |   |
| Deferred income taxes                                                                                                                                     |       | 58,217                |       | 42,871 |   |
| Other                                                                                                                                                     |       | 5,685                 |       | 15,491 |   |
| Total other assets                                                                                                                                        |       | 199,873               |       | 208,267 |   |
|                                                                                                                                                      |       | $                     | 1,309,155  |   | $ | 1,170,913 |   |
| **Liabilities  and Stockholders’ Equity**                                                                                                            |       |                  |       |   |   |
| **Current Liabilities:**                                                                                                                                  |       |                  |       |   |   |
| Notes payable and bank overdrafts                                                                                                                         |       | $                     | 46,952     |   | $ | 28,275 |   |
| Long-term debt due within one year                                                                                                                        |       | 120,243               |       | 168,548 |   |
| Accounts payable                                                                                                                                          |       | 142,234               |       | 107,090 |   |
| Accrued salaries and wages                                                                                                                                |       | 56,923                |       | 44,035 |   |
| Accrued warranty                                                                                                                                          |       | 17,022                |       | 17,047 |   |
| Other accrued liabilities                                                                                                                                 |       | 54,588                |       | 46,312 |   |
| Total current liabilities                                                                                                                                 |       | 437,962               |       | 411,307 |   |
| **Long-Term Debt**                                                                                                                                        |       | 182,388               |       | 135,452 |   |
| **Other  Liabilities**                                                                                                                                    |       |                  |       |   |   |
| Long-term pension liability                                                                                                                               |       | 80,607                |       | 49,590 |   |
| Postretirement benefits other than pensions                                                                                                               |       | 35,193                |       | 19,461 |   |
| Deferred income taxes                                                                                                                                     |       | 30,590                |       | 44,277 |   |
| Other                                                                                                                                                     |       | 22,976                |       | 20,464 |   |
| Total other liabilities                                                                                                                                   |       | 169,366               |       | 133,792 |   |
| **Minority Interest in Net Assets of Consolidated  Companies**                                                                                            |       | 53,448                |       | 51,440 |   |
| **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 2006 and 2005; issued and outstanding 47,746,279 in 2006  and 47,498,232 in 2005 |       | 477                   |       | 475 |   |
| Additional paid-in capital                                                                                                                                |       | 336,146               |       | 332,861 |   |
| Retained earnings                                                                                                                                         |       | 103,278               |       | 78,176 |   |
| Accumulated other comprehensive income                                                                                                                    |       | 26,090                |       | 27,410 |   |
| Total stockholders’ equity                                                                                                                           |       | 465,991               |       | 438,922 |   |
|                                                                                                                                                      |       | $                     | 1,309,155  |   | $ | 1,170,913 |   |

 

See accompanying notes to consolidated financial statements.

F-2

----

**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,  2004:**            | ** ** |                                        | ** ** | ** **        |       |                                     | ** ** | ** **             |       |                                              | ** ** | ** **                                           |       |      | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Beginning balance                                  |       |                                        | 47,432,268 | ** **        |       |                                     | $          | 474                    | ** ** |                                              |       | $                                                    | 314,319    |      |       |   | $ | 45,202 |   |   |   | $ | 37,376 |   |   |   | $ | (157 | ) |   | $ | 397,214 |   |
| 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 |   |
| Restricted stock grant                             |       |                                        | 13,500     | ** **        |       |                                     | —     | ** **             |       |                                              | 208        |                                                 |       |      | —     |   |   |   | — |   |   |   | (208 | ) |   | — |   |
| Restricted stock and performance unit compensation |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | 5,344      |                                                 |       |      | —     |   |   |   | — |   |   |   | 128 |   |   | 5,472 |   |
| 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 gains 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 |   |
| **Year  Ended December 31, 2006:**            | ** ** |                                        | ** ** | ** **        |       |                                     | ** ** | ** **             |       |                                              | ** ** | ** **                                           |       |      | ** ** | ** ** |   |   | ** ** | ** ** |   |   | ** ** | ** ** |   | ** ** | ** ** |
| Comprehensive income:                              |       |                                        |       | ** **        |       |                                     |       | ** **             |       |                                              |       |                                                 |       |      |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Net income                                         |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | —     |                                                 |       |      | 53,748     |   |   |   | — |   |   |   | — |   |   |   |   |
| Pension and postretirement adjustment              |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | —     |                                                 |       |      | —     |   |   |   | (40,256 | ) |   |   | — |   |   |   |   |
| Unrealized gains on hedging activities             |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | —     |                                                 |       |      | —     |   |   |   | 847 |   |   |   | — |   |   |   |   |
| Currency translation                               |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | —     |                                                 |       |      | —     |   |   |   | 38,089 |   |   |   | — |   |   |   |   |
| Total comprehensive income                         |       |                                        |       | ** **        |       |                                     |       | ** **             |       |                                              |       |                                                 |       |      |       |   |   |   |   |   |   |   |   |   |   | 52,428 |   |
| Performance units vested                           |       |                                        | 234,547    | ** **        |       |                                     | 2          | ** **             |       |                                              | —     |                                                 |       |      | —     |   |   |   | — |   |   |   | — |   |   | 2 |   |
| Restricted stock grant                             |       |                                        | 13,500     | ** **        |       |                                     | —     | ** **             |       |                                              | —     |                                                 |       |      | —     |   |   |   | — |   |   |   | — |   |   | — |   |
| Restricted stock and performance unit compensation |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | 6,292      |                                                 |       |      | —     |   |   |   | — |   |   |   | — |   |   | 6,292 |   |
| Tax benefits on performance unit compensation      |       |                                        |       | ** **        |       |                                     |       | ** **             |       |                                              | 137        |                                                 |       |      |       |   |   |   |   |   |   |   |   |   |   | 137 |   |
| Minimum tax witholding settlement                  |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | (3,144     | )                                                    |       |      | —     |   |   |   | — |   |   |   | — |   |   | (3,144 | ) |
| Cash dividends declared ($.60 per share)           |       |                                        | —     | ** **        |       |                                     | —     | ** **             |       |                                              | —     |                                                 |       |      | (28,646    | ) |   |   | — |   |   |   | — |   |   | (28,646 | ) |
| Ending Balance                                     |       |                                        | 47,746,279 | ** **        |       |                                     | $          | 477                    | ** ** |                                              |       | $                                                    | 336,146    |      |       |   | $ | 103,278 |   |   |   | $ | 26,090 |   |   |   | $ | — |   |   | $ | 465,991 |   |

 

See accompanying notes to consolidated financial statements.

F-3

----

**Sauer-Danfoss Inc.and SubsidiariesConsolidated Statements of Cash Flows(Dollars in thousands)**

| ** **                                                                                               | ** ** | **For the Years Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2006**                                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| **Cash Flows from Operating  Activities:**                                                               |       |                                                          |       |   |   |   |   |
| Net Income                                                                                               |       | $                                                             | 53,748     |   | $ | 38,715 |   | $ | 33,186 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities:            |       |                                                          |       |   |   |   |   |
| Depreciation and amortization                                                                            |       | 95,665                                                        |       | 88,322 |   | 82,363 |   |
| Minority interest                                                                                        |       | 21,617                                                        |       | 18,657 |   | 21,522 |   |
| Restricted stock and performance unit compensation  under equity method                                  |       | 6,292                                                         |       | 9,683 |   | 5,344 |   |
| Impairment charge and net loss on disposal of fixed  assets                                              |       | 3,246                                                         |       | 1,391 |   | 2,119 |   |
| Change in deferred income taxes                                                                          |       | (13,909                                                       | )          | (12,449 | ) | (2,174 | ) |
| (Increase)  decrease in operating assets and liabilities, excluding effects of  acquisitions — |       |                                                          |       |   |   |   |   |
| Accounts receivable, net                                                                                 |       | (24,512                                                       | )          | (4,829 | ) | (30,780 | ) |
| Inventories                                                                                              |       | (14,242                                                       | )          | (24,860 | ) | (23,466 | ) |
| Accounts payable                                                                                         |       | 27,244                                                        |       | (13,368 | ) | 22,705 |   |
| Accrued liabilities                                                                                      |       | 8,511                                                         |       | 17,621 |   | 10,191 |   |
| Other                                                                                                    |       | 4,252                                                         |       | (2,571 | ) | 3,802 |   |
| Net cash provided by operating activities                                                                |       | 167,912                                                       |       | 116,312 |   | 124,812 |   |
| **Cash  Flows from Investing Activities:**                                                               |       |                                                          |       |   |   |   |   |
| Purchases of property, plant and equipment                                                               |       | (116,244                                                      | )          | (95,247 | ) | (79,257 | ) |
| Payments for acquisitions and license rights, net of  cash acquired                                      |       | —                                                        |       | — |   | (5,656 | ) |
| Proceeds from sales of property, plant and equipment                                                     |       | 6,959                                                         |       | 1,942 |   | 9,367 |   |
| Net cash used in investing activities                                                                    |       | (109,285                                                      | )          | (93,305 | ) | (75,546 | ) |
| **Cash  Flows from Financing Activities:**                                                               |       |                                                          |       |   |   |   |   |
| Net borrowings (repayments) on notes payable and bank  overdrafts                                        |       | 20,351                                                        |       | 7,598 |   | (14,978 | ) |
| Net borrowings (repayments) on revolving credit  facility                                                |       | (37,918                                                       | )          | (62,355 | ) | 33,420 |   |
| Repayments of long-term debt                                                                             |       | (32,137                                                       | )          | (13,253 | ) | (42,355 | ) |
| Borrowings of long-term debt                                                                             |       | 51,517                                                        |       | 77,190 |   | — |   |
| Payments for debt financing costs                                                                        |       | (285                                                          | )          | (898 | ) | — |   |
| Performance unit compensation excess tax deduction                                                       |       | 137                                                           |       | — |   | — |   |
| Cash dividends                                                                                           |       | (26,706                                                       | )          | (21,843 | ) | (14,706 | ) |
| Distribution to minority interest partners                                                               |       | (19,908                                                       | )          | (6,570 | ) | (14,711 | ) |
| Net cash used in financing activities                                                                    |       | (44,949                                                       | )          | (20,131 | ) | (53,330 | ) |
| **Effect of Exchange Rate Changes on Cash**                                                              |       | 1,240                                                         |       | 45 |   | 251 |   |
| **Cash and  Cash Equivalents:**                                                                          |       |                                                          |       |   |   |   |   |
| Net increase (decrease) during the year                                                                  |       | 14,918                                                        |       | 2,921 |   | (3,813 | ) |
| Beginning balance                                                                                        |       | 14,194                                                        |       | 11,273 |   | 15,086 |   |
| Ending balance                                                                                           |       | $                                                             | 29,112     |   | $ | 14,194 |   | $ | 11,273 |   |
| **Supplemental  Cash Flow Disclosures:**                                                                 |       |                                                          |       |   |   |   |   |
| Interest paid                                                                                            |       | $                                                             | 17,163     |   | $ | 15,601 |   | $ | 17,984 |   |
| Income taxes paid                                                                                        |       | $                                                             | 25,337     |   | $ | 14,780 |   | $ | 12,324 |   |

 

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, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

***Basis of Presentation andPrinciples 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 recordedwhen all of the following criteria are met: persuasive evidence of anarrangement exists, delivery has occurred, the price is fixed and determinable,and collectibility is reasonably assured. Estimates for future warranty expenseare recorded when the related revenue is recognized. Timing of revenuerecognition is consistent with when the risks and rewards of ownership andtitle to the product have transferred to the customer.

***Cash and Cash Equivalents —***

Cash equivalents areconsidered by the Company to be all highly liquid instruments purchased withoriginal maturities of three months or less. At December 31, 2006 cash andcash equivalents balances in China totaled approximately $23,000. The Companyis paying dividends from its Chinese entities to the maximum extent possibleunder current regulations, however,****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 the country.

***Trade Receivables —***

The Company records tradereceivables due from its customers at the time sales are recorded in accordancewith its revenue recognition policy. The future collectibility of these amountscan be impacted by the Company’s collection efforts, the financial stability ofits customers, and the general economic climate in which it operates. TheCompany applies a consistent practice of establishing an allowance for accountsthat it believes may become uncollectible through reviewing the historicalwrite-offs of accounts, 

F-5

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

aging ofits receivables, and by monitoring the financial strength of its customers. Ifthe Company becomes aware of a customer’s inability to meet its financialobligations (e.g., where it has filed for bankruptcy), the Company establishesa specific allowance for the potential bad debt to reduce the net recognizedreceivable to the amount it reasonably believes will be collected. Thevaluation of trade receivables is performed quarterly.

***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 and FIFO, cost methods was 19% and 81%,respectively, for 2006, and 18% and 82%, respectively, for 2005.

***Property, Plant and Equipment andDepreciation —***

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 ($41,729,$38,697, and $36,533 in 2006, 2005, and 2004, 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 Other IntangibleAssets —***

Goodwill represents theexcess of the purchase price over the estimated fair values of net assetsacquired in the purchase of businesses. The Company accounts for goodwill andintangible assets in accordance with Statement of Financial AccountingStandards (SFAS) No. 142, “Goodwill and Other Intangible Assets,” whichrequires that goodwill is not amortized, but tested for impairment at leastannually. Intangible assets consist primarily of trade names, technology, andcustomer relationships and are recorded at cost or fair value at the time ofacquisition. Intangible assets are amortized on a straight-line basis overtheir legal or estimated useful lives, which range from three to thirty fiveyears.

***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 

F-6

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

currently under warranty,historical and anticipated rates of warranty claims on those units and the costper claim to satisfy the Company’s warranty obligation. The anticipated rate ofwarranty claims is the primary factor impacting the Company’s estimatedwarranty obligation. Each quarter, the Company reevaluates its estimates toassess the adequacy of its recorded warranty liabilities and adjusts theamounts 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 of Long-Lived Assetsand Assets to be Disposed Of —***

Consistent with therequirements of SFAS No. 144, “Accounting for the Impairment or Disposalof Long-Lived Assets,” the Company periodically assesses whether events orcircumstances have occurred that may indicate the carrying value of itslong-lived tangible and intangible assets may not be recoverable. The carryingvalue of long-lived tangible and intangible assets to be held and used isevaluated based on the expected future undiscounted operating cash flows. Whenevents or circumstances indicate the carrying value of an asset or group ofassets is impaired, the Company recognizes an impairment loss to the extentthat the carrying value of the assets exceeds the fair value of the assets. In2006 the Company recognized an impairment of long-lived assets to be disposedof related to restructuring activity in the Work Function segment of approximately$1,500 (see Note 3 for more information).

***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 —***

Basicnet income per common share is based on the weighted average number of commonshares outstanding in each year. Diluted net income per common share assumesthat outstanding common shares were increased by shares issuable upon (i) exerciseof restricted stock shares, and (ii) granting of shares under thelong-term incentive plan, after it becomes certain that the performancerequirements needed to 

F-7

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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, 2006          |       |                |       |       |       |    |       |   |   |
| Basic net income                |       |                | $          | 53,748     |       |    | 47,699,972 |   | $ | 1.13 |   |
| Effect of dilutive  securities: |       |                |       |       |       |    |       |   |   |
| Restricted stock                |       |                | —     |       |       | 22,768  |       | — |   |
| Performance units               |       |                | —     |       |       | 515,074 |       | (0.02 | ) |
| Diluted net  income             |       |                | $          | 53,748     |       |    | 48,237,814 |   | $ | 1.11 |   |
| 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 |   |

 

***Fair Value of Financial Instruments —***

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

The fair value oflong-term debt is calculated by discounting scheduled cash flows throughmaturity using estimated market discount rates. The discount rate is estimatedusing the rates currently offered for long-term debt of similar remainingmaturities. At December 31, 2006 the Company estimated the fair value ofits long-term debt, including amounts due within one year, at $302,979 comparedto its carrying value of $302,631. At December 31, 2005 the Companyestimated the fair value of its long-term debt, including amounts due withinone year, at $307,550 compared to its carrying value of $304,000. Theseestimates are subjective in nature and involve uncertainties and, therefore,cannot be determined with precision. Changes in assumptions could significantlyaffect these estimates.

***Translation of Non-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’ 

F-8

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

equity.Gains or losses on transactions denominated in non-functional currencies andthe related tax effects are reflected in the consolidated statements of income.

***Derivatives and Hedging —***

It is the Company’s policythat derivative transactions are executed only to manage exposures arising inthe normal course of business and not for the purpose of creating speculativepositions or trading. Derivative financial instruments are accounted for underSFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities,” as amended. Under SFAS No. 133, all derivatives are recordedat fair value on the balance sheet as current or long-term other assets or otherliabilities depending on whether the maturity date of the derivative contractis within one year from the balance sheet date.

The Company uses interestrate swaps to establish fixed interest rates on outstanding borrowings. Thereis no ineffectiveness of the interest rate swaps and therefore, the changes infair value of the derivatives is recorded in accumulated other comprehensiveincome. The Company utilizes forward contracts to minimize the impact ofcurrency fluctuations on cash flows related to forecasted sales denominated incurrencies other than the functional currency of the selling location. Theforward contracts qualify for hedge accounting and therefore are subject toeffectiveness testing at the inception of the contract and throughout the lifeof the contract.

When, and if, a derivativeis determined not to be highly effective as a hedge, or the underlying hedgedtransaction is no longer likely to occur, or the derivative is terminated, thehedge accounting is discontinued and any past or future changes in thederivative’s fair value that will not be effective as an offset to the incomeeffects of the item being hedged are recognized currently in the incomestatement. Any changes in fair values of derivatives not qualifying as hedgeswould be reported immediately in other income (expense) on the consolidatedstatement of income, however, the Company did not have any derivatives that didnot qualify as hedges in 2006 or 2005.

***Employee Stock-Based Compensation —***

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

***New Accounting Principles —***

In November 2004 theFinancial Accounting Standards Board (FASB) issued SFAS No. 151, “InventoryCosts.” SFAS No. 151 amends Accounting Research Bulletin No. 43,Chapter 4 on inventory pricing to clarify that abnormal amounts of idlefacility expense, freight, handling costs, and wasted materials should berecognized as current period charges. In addition, SFAS No. 151 requiresthat allocation of fixed production overhead to the costs of conversion bebased on the normal capacity of the production facilities. The Company adoptedSFAS No. 151 in 2006 with no material effect on the Company’s consolidatedfinancial statements.

In September 2006 theFASB issued SFAS No. 158, “Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans an amendment of SFAS No. 87, 88,106, and 132(R).” This 

F-9

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

standardrequires employers to recognize the underfunded or overfunded status of adefined benefit postretirement plan as an asset or liability in its balancesheet and to recognize changes in the funded status in the year in which thechanges occur through accumulated other comprehensive income. Additionally,SFAS No. 158 requires employers to measure the funded status of a plan asof the date of its fiscal year-end. The Company adopted SFAS No. 158 in2006. The effect of adoption was to decrease assets by $1,438, increase liabilitiesby $27,888, and decrease accumulated other comprehensive income by $29,326. Thenew measurement date requirement applies for fiscal years ending after December 15,2008. The Company already uses a measurement date of December 31 so thischange will have no impact on the consolidated financial statements.

In September 2006 theU.S. Securities and Exchange Commission staff issued Staff Accounting Bulletin No. 108(“SAB 108”), “Considering the Effects of Prior Year Misstatements whenQuantifying Misstatements in Current Year Financial Statements.” SAB 108requires quantification of financial statement misstatements based on theeffects of the misstatements on each of the company’s financial statements andthe related financial statement disclosures. The Company adopted SAB 108in 2006 with no impact on the consolidated financial statements.

In June 2006 the FASBissued FASB Interpretation No. 48, “Accounting for Uncertainty in IncomeTaxes — an interpretation of FASB Statement No. 109” (FIN 48),which prescribes a recognition threshold and measurement attribute for thefinancial statement recognition and measurement of a tax position taken orexpected to be taken in a tax return. FIN 48 also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure and transition. FIN 48 is effective for fiscal yearsbeginning after December 15, 2006. The Company does not expect theadoption of FIN 48 to have a material impact on financial reporting and iscurrently evaluating the impact, if any, the adoption of FIN 48 will haveon the consolidated financial statements.

In June 2006 the FASBratified Emerging Issues Task Force (“EITF”) Issue No. 06 — 3, “HowTaxes Collected from Customers and Remitted to Governmental Authorities ShouldBe Presented in the Income Statement (that is, Gross versus Net Presentation)”,which allows companies to adopt a policy of presenting taxes in the incomestatement on either a gross or net basis. Taxes within the scope of this EITFwould include taxes that are imposed on a revenue transaction between a sellerand a customer. If such taxes are significant, the accounting policy should bedisclosed as well as the amount of taxes included in the financial statementsif presented on a gross basis. EITF No. 06 — 3 is effective forreporting periods beginning after December 15, 2006. The Company does notexpect the adoption of EITF No. 06 — 03 to have a significant impacton the consolidated financial statements.

In September 2006FASB issued SFAS No. 157, “Fair Value Measurements” which clarifies theprinciple that fair value should be based on the assumptions that marketparticipants would use when pricing an asset or liability. Additionally, itestablishes a fair value hierarchy that prioritizes the information used todevelop those assumptions. The Company has not yet determined the impact thatthe implementation of SFAS No. 157 will have on the consolidated financialstatements. SFAS No. 157 is effective for financial statements issued forfiscal years beginning after November 15, 2007.

In February 2007 theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities — Including an Amendment of FASB Statement No. 115.”SFAS No. 159 permits 

F-10

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

manyfinancial instruments and certain other items to be measured at fair value atthe option of the Company. SFAS No. 159 is effective for financialstatements issued for first fiscal years beginning after November 15,2007. The Company does not expect the adoption of SFAS 159 to have asignificant impact on the consolidated financial statements.

***Reclassifications —***

Certainpreviously reported amounts have been reclassified to conform to the currentperiod presentation. Spare machining parts and perishable tooling totalingapproximately $6,500 at December 31, 2005 was reclassified from inventoryto other assets in the current year.

**(2) Business Combinations:**

Duringthe second quarter of 2004 the Company exercised its option to acquire theremaining 15% of Comatrol S.p.A for approximately $4,300. The Company acquiredComatrol, located in Reggio Emilia, Italy, with approximately 100 employees and$22,000 in annual sales, for its manufacturing and product technology. In thesecond quarter of 2003, the Company purchased 40% of the outstanding shares ofComatrol, increasing its ownership percentage to 85%, and therefore began toconsolidate the financial results of the business. The total purchase pricepaid to acquire Comatrol was approximately $22,100. The Company recognizedintangible assets of approximately $600 and $2,200 for technology and customerrelationships, respectively, in connection with the Comatrol acquisition. Thetransaction also resulted in recognizing approximately $14,500 of goodwill inthe Controls segment.

**(3) Restructuring Charges:**

In March 2006 theCompany announced its plans to close the LaSalle, Illinois, plant, and discontinueproduction of certain product lines manufactured in Swindon, England. Certainproducts currently manufactured in LaSalle were outsourced to reduce costs andincrease efficiencies. The total cost of the restructuring activities atLaSalle and Swindon are expected to be approximately $8,500 and $4,800,respectively. Costs related to the LaSalle plant closing are included in thePropel segment and are anticipated to be completed by the end of the firstquarter 2007. Costs related to the Swindon product line discontinuance areincluded in the Work Function segment and are anticipated to be completed bythe end of the third quarter 2007. In addition the Propel and Controls segmentshave incurred costs related to smaller restructuring activities. Other than theaccrual of employee termination costs, the restructuring charges are expensedas incurred.

F-11

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

Thefollowing table summarizes the restructuring charges incurred in 2006:

| ** **                                               | ** ** | **Propel** | ** ** | **Work  Function** | ** ** | **Controls** | ** ** | **Total** | ** ** |
|----------------------------------------------------------|------------|------------|------------|--------------------|------------|--------------|------------|-----------|------------|
| Employee  termination costs                              |       | $          | 1,572      |               |       | $            | 1,915      |      |       |   | $ | 271 |   |   | $ | 3,758 |   |
| Property and  equipment impairment and loss on  disposal |       | 309        |       |               | 1,567      |         |       |      | 290        |   |   | 2,166 |   |
| Accelerated  depreciation due to change in useful lives  |       | 2,086      |       |               | —     |         |       |      | —     |   |   | 2,086 |   |
| Pension  curtailment                                     |       | 1,551      |       |               | —     |         |       |      | —     |   |   | 1,551 |   |
| Production  inefficiencies                               |       | 1,064      |       |               | —     |         |       |      | —     |   |   | 1,064 |   |
| Equipment moving  costs                                  |       | 740        |       |               | —     |         |       |      | 620        |   |   | 1,360 |   |
| Other                                                    |       | 968        |       |               | —     |         |       |      | 543        |   |   | 1,511 |   |
| Total                                                    |       | $          | 8,290      |               |       | $            | 3,482      |      |       |   | $ | 1,724 |   |   | $ | 13,496 |   |

 

Costs incurred during the year ended December 31,2006 consist of $10,855, $475, and $2,166 included in cost of sales; selling,general and administrative expenses; and impairment charges and net loss ondisposal of fixed assets, respectively. The amount for pension curtailment isthe recognition of unamortized prior service costs related to the LaSallepension plan.

Nosignificant restructuring projects were underway in 2005. The Company completedrestructuring of its European sales and distribution operations in 2004. During2004 the Company also completed the relocation of the operations of its WestBranch, Iowa, location to other existing facilities and outsourced certainprocesses to reduce costs and increase efficiencies. The costs related to theWest Branch restructuring and to management reorganization 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:

| ** **                                              | ** ** | **Work Function** | ** ** | **European Sales  Operations** | ** ** |
|---------------------------------------------------------|------------|------------------------|------------|-------------------------------------|------------|
| ** **                                              | ** ** | ** **             | **2004**   | ** **                          | ** ** | ** ** | **2004** | ** ** | ** ** |
| Employee  termination costs                             |       |                   | $          | 1,338                               |       |   |   | $ | 2,323 |   |   |
| Employee  retraining & relocation costs        |       |                   | 148        |                                |       |   | 176 |   |   |
| Property and  equipment impairment and loss on disposal |       |                   | 131        |                                |       |   | — |   |   |
| Coordinating team                                       |       |                   | —     |                                |       |   | 1,166 |   |   |
| Equipment  relocation costs                             |       |                   | 136        |                                |       |   | — |   |   |
| Other costs                                             |       |                   | 470        |                                |       |   | 743 |   |   |
| Total                                                   |       |                   | $          | 2,223                               |       |   |   | $ | 4,408 |   |   |

 

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 West Branch relocation wascompleted in March 2004. The European sales and distribution restructuringwas completed in December 2004.

F-12

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

Thefollowing table summarizes the activity in the restructuring accrued liabilityfor the years ended December 31, 2006, 2005, and 2004.

| ** **                    | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance at  beginning of year |       | $        | —     |     |       | $        | —     |   |   | $ | — |   |
| Charges to  expense           |       | 3,758    |       |     | —     |     |       | 3,661 |   |
| Severence  payments made      |       | (643     | )          |     | —     |     |       | (3,661 | ) |
| Balance at end of year        |       | $        | 3,115      |     |       | $        | —     |   |   | $ | — |   |

 

**(4) Inventories:**

Thecomposition of inventories is as follows:

| ** **                | ** ** | **December 31,** | ** ** |
|---------------------------|------------|-----------------------|------------|
| ** **                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Raw materials             |       | $                     | 116,122    |   | $ | 95,434 |   |
| Work in progress          |       | 56,274                |       | 59,583 |   |
| Finished goods  and parts |       | 117,104               |       | 98,530 |   |
| LIFO allowance            |       | (17,214               | )          | (14,642 | ) |
| Total                     |       | $                     | 272,286    |   | $ | 238,905 |   |

 

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

Thecost and related accumulated depreciation of property, plant and equipment aresummarized as follows:

| ** **                                | ** ** | **December 31,** | ** ** |
|-------------------------------------------|------------|-----------------------|------------|
| ** **                                | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Cost —                          |       |                  |       |   |   |
| Land and improvements                     |       | $                     | 16,063     |   | $ | 15,134 |   |
| Buildings and improvements                |       | 132,418               |       | 117,901 |   |
| Machinery and equipment                   |       | 1,044,030             |       | 981,647 |   |
| Construction in progress                  |       | 79,433                |       | 42,778 |   |
| Plant and  equipment under capital leases |       | 16,694                |       | 15,447 |   |
| Total costs                               |       | 1,288,638             |       | 1,172,907 |   |
| Less — accumulated depreciation |       | (784,661              | )          | (722,481 | ) |
| Net property, plant and  equipment        |       | $                     | 503,977    |   | $ | 450,426 |   |

 

Depreciation expense for 2006, 2005, and 2004 was$92,902, $85,346, and $79,307, respectively.

In connection with the discontinuation of certainproduct lines discussed in Note 3 the Company intends to sell or dispose of therelated machinery and equipment. The Company recorded an impairment charge ofapproximately $1,500 when it reduced the carrying value of these assets to theirfair market value, calculated based on expected sales price. During 2001 theCompany closed a manufacturing facility in Racine, Wisconsin, as part of arestructuring related to an acquisition. In 2004 this property was sold and 

F-13

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

a gain on sale ofapproximately $600 was recognized in the income statement in the GlobalServices segment results. The Company also had an undeveloped piece of land inBrooklyn Park, Minnesota, which had a carrying value of approximately $3,000,which was classified in other current assets on the consolidated balance sheetat December 31, 2005. In 2006 this property was sold and a gain of $100was recognized in the income statement in the Controls segment results.

In2003 the Company closed a manufacturing facility in West Branch, Iowa anddetermined the land and building would be sold. This property is classified inother current assets with a carrying value of approximately $3,600 in the WorkFunction segment on the consolidated balance sheets at December 31, 2006and 2005 as it is held for sale. Based upon its most recent analysis, theCompany believes that no impairments existed at December 31, 2006.

**(6) IntangibleAssets:**

Thefollowing table summarizes the components of the other intangible assetbalances at December 31, 2006 and 2005:

| ** **                    | ** ** | **Trade  Name** | ** ** | **Technology** | ** ** | **Customer  Relationships** | ** ** | **Other** | ** ** | **Total** | ** ** |
|-------------------------------|------------|-----------------|------------|----------------|------------|-----------------------------|------------|-----------|------------|-----------|------------|
| *December 31, 2006*      | * *   | * *        | * *   |           | * *   | * *                    |       |      | * *   | * *  |       | * * | * * | * * | * * |
| Cost                          |       | $               | 19,000     |           |       | $                           | 11,324     | * *  |       |      | $          | 6,670 | * * |   | $ | 2,615 |   | $ | 39,609 |   |
| Accumulated  amortization     |       | (3,258          | )          |           | (4,866     | *)*                         |       |      | (3,123     | *)*       |       | (1,202 | ) | (12,449 | ) |
| Other intangible  assets, net |       | $               | 15,742     |           |       | $                           | 6,458      | * *  |       |      | $          | 3,547 | * * |   | $ | 1,413 |   | $ | 27,160 |   |
| *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 |   |

 

The weighted average useful lives for the intangibleassets are 35, 14, and 12 years for trade name, technology, and customerrelationships, respectively. Amortization of intangible assets was $2,763,$2,976, and $3,056 in 2006, 2005, and 2004, respectively. Amortization expenseis expected to be approximately $1,800 in 2007, $1,600 in 2008, and $1,500 in2009 through 2011.

F-14

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

**(7)** Long-TermDebt:

Long-termdebt outstanding at December 31, 2006 and 2005 consisted of the following:

| ** **                                              | ** ** | **2006**                                                | ** ** | **2005**            | ** ** |
|---------------------------------------------------------|------------|---------------------------------------------------------|------------|---------------------|------------|
| ** **                                              | ** ** | **Long-term debt  due within  one year** | ** ** | **Long-term  debt** | ** ** | **Long-term debt  due within  one year** | ** ** | **Long-term  debt** | ** ** |
| Multicurrency  Revolving and Term Loan Facility         |       |                                                    | $          | 106,374             |       |   | $ | 52,106 |   |   | $ | 98,268 |   |   | $ | — |   |
| Danish Revolving  Credit Facility                       |       |                                                    | —     |                |       | — |   |   | 56,278 |   |   | — |   |
| German Long-Term  Bank Facilities maturing through 2018 |       |                                                    | 9,802      |                |       | 11,212 |   |   | 9,820 |   |   | 18,952 |   |
| Multicurrency  Term Loan Facility due through 2015      |       |                                                    | —     |                |       | 80,512 |   |   | — |   |   | 75,556 |   |
| U.S. 1997 Senior  Notes, due through 2007               |       |                                                    | 4,000      |                |       | — |   |   | 4,000 |   |   | 4,000 |   |
| U.S. 2000 Senior  Notes, due through 2010               |       |                                                    | —     |                |       | 35,000 |   |   | — |   |   | 35,000 |   |
| Other Borrowings                                        |       |                                                    | 67         |                |       | 3,558 |   |   | 182 |   |   | 1,944 |   |
| Total                                                   |       |                                                    | $          | 120,243             |       |   | $ | 182,388 |   |   | $ | 168,548 |   |   | $ | 135,452 |   |

 

*Multicurrency andNon-U.S. Bank Facilities*

In December 2005 the Company entered into aMulticurrency Revolving Facility Agreement which was modified in July 2006(the Agreement). Under the Agreement the Company may borrow up to $300,000through December 2010. The Agreement includes a 40,000 euro term loanwhich expires in July 2013. Proceeds from the term loan were used to payoff a portion of the Company’s revolving credit balances. Debt issuance costsof approximately $1,000 were capitalized and are being amortized to interestexpense over the term of the Agreement. Any amounts drawn under the revolvingportion of the facility must be repaid or reborrowed within 360 days. Therevolving portion of this facility is classified as current and the 40,000 euroterm loan is classified as long-term.

Borrowings under the Agreement bear interest at a ratebased on either the relevant interbank offering rate plus a margin (0.625% at December 31,2006), 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 approximately5.6% at December 31, 2006. 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.This fee was 0.15% at December 31, 2006 and the Company incurredcommitment fee expense of $310 and $12 in 2006 and 2005, respectively. TheAgreement contains certain financial covenants relating to the Company’s EBITDAto net interest expense and net debt to EBITDA, as defined. The Company was incompliance with the covenants at December 31, 2006.

The Agreement was a modification of the MulticurrencyRevolving Credit Facility Agreement that the Company had entered into in September 2003(the Prior Agreement). The Company incurred $468 of commitment fee expenserelated to the Prior Agreement in 2005.

F-15

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The Company also had arevolving credit facility of 800,000 Danish kroner that was available through June 2006.At December 31, 2005 the Company had 447,149 Danish kroner or $71,254available under this facility. The interest rate on the loans outstanding at December 31,2005 was 3.4%. In addition, the Company was required to pay a commitment fee onthe unused portion of this credit facility, which was at a rate of 0.50% at December 31,2005. The Company incurred $114 and $71 of commitment fee expense in 2006 and2005, respectively.

The German Long-Term BankFacilities represent a series of long-term and short-term bank loans. Includedin the balance of $21,014 are loans with $14,900 outstanding at December 31,2006 that are secured by property. Interest on the German facilities may beeither fixed or variable depending on the individual loan. Interest rates rangefrom 4.1% to 6.0% at December 31, 2006. These facilities contain a varietyof repayment schedules and have final maturities ranging from June 2007through June 2018.

In December 2005 theCompany borrowed $75,000 under a new term loan facility. The Company borrowed$30,000 in U.S. dollars at a fixed interest rate of 5.74% and 38,450 euro at afixed interest rate of 4.05% over the ten year term of the loan. The europortion of the loan is allocated to a Danish subsidiary.Sauer-Danfoss Inc. guarantees these euro borrowings including interest,amortization and fees. Repayments on the term loan are scheduled from December 2011through December 2015. The outstanding balance on this loan at December 31,2006 was $80,512. The Agreement contains certain financial covenants relatingto the Company’s EBITDA to net interest expense and net debt to EBITDA, asdefined, which the Company was in compliance with at December 31, 2006.

***U.S. Borrowings***

In December 1997 theCompany issued $25,000 of 6.68% Senior Notes (1997 Senior Notes), of which$4,000 remains outstanding at December 31, 2006. The 1997 Senior Noteshave one remaining repayment on December 15, 2007. The 1997 Senior Notescontain certain restrictions and require the maintenance of minimum tangiblenet worth and maximum leverage, as defined. At December 31, 2006 theCompany was in compliance with these requirements.

In October 2000 theCompany issued $35,000 of 8.07% Senior Notes (2000 Senior Notes). The 2000Senior Notes have scheduled annual payments starting on September 30,2008, through September 30, 2010. The 2000 Senior Notes contain certainrestrictions and require the maintenance of certain financial ratios that aresimilar to the 1997 Senior Notes. At December 31, 2006 the Company was incompliance with these requirements.

The Company maintainsoverdraft facilities in various currencies in multiple countries for cashmanagement purposes. The interest rates and commitment fees vary by country andarrangement. At December 31, 2006 there was $46,952 outstanding under theoverdraft facilities. A Danish subsidiary maintains a line of credit forpurposes of centralizing cash management for the European locations.Sauer-Danfoss Inc. guarantees this line of credit up to 20,000 euro.

Payments required to bemade on long-term debt outstanding as of December 31, 2006 during theyears ending 2007 through 2011 and for 2012 and thereafter are $120,243,$14,554, $13,292, $20,360, $28,513, and $105,669, respectively.

F-16

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The Company has noncontributory defined benefitpension plans covering a significant number of its employees. The benefitsunder these plans are based primarily on years of service and compensationlevels. The Company also provides health benefits for certain retired employeesand certain dependents when the employee becomes eligible for these benefits bysatisfying plan provisions that include certain age and service requirements.The measurements for the pension and health benefits plans were performed at December 31.

TheCompany has adopted the provisions of SFAS No. 158, “Employers’ Accountingfor Defined Benefit Pension and Other Postretirement Plans, an amendment ofFASB Statements No. 87, 88, 106, and 132(R)” in December 2006. Inaccordance with SFAS 158, the 2005 accounting and related disclosures were notadjusted by the adoption of the new standard. The table below summarizes theincremental effects of the adoption of SFAS No. 158 on the individual lineitems in the Consolidated Balance Sheet at December 31, 2006:

| ** **                                  | ** ** | **Pre SFAS  No. 158  Adoption** | ** ** | **SFAS  No. 158  Adjustment** | ** ** | **Post SFAS  No. 158  Adoption** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|------------------------------------|------------|--------------------------------------------|------------|
| Assets:                                     |       |                                      |       |                               |       |                                       |       |   |   |   |   |   |   |
| Other assets                                |       |                                      | $          | 13,469                             |       |                                       |       | $ | (13,242 | ) |   |   | $ | 227 |   |   |
| Deferred income taxes                       |       |                                      | 3,232      |                               |       |                                       | 11,804     |   |   |   | 15,036 |   |   |
| Liabilities:                                |       |                                      |       |                               |       |                                       |       |   |   |   |   |   |   |
| Other accrued liabilities                   |       |                                      | 10,012     |                               |       |                                       | (5,460     | ) |   |   | 4,552 |   |   |
| Long-term pension liability                 |       |                                      | 64,868     |                               |       |                                       | 15,739     |   |   |   | 80,607 |   |   |
| Post retirment benefits other than pensions |       |                                      | 17,584     |                               |       |                                       | 17,609     |   |   |   | 35,193 |   |   |
| Stockholders’ equity:                  |       |                                      |       |                               |       |                                       |       |   |   |   |   |   |   |
| Accumulated other  comprehensive income     |       |                                      | 22,483     |                               |       |                                       | 29,326     |   |   |   | 51,809 |   |   |
|                                             |            |                                           |            |                                    |            |                                            |            |  |  |  |  |  |  |  |  |  |

 

*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 payments aremade to retirees, and the unfunded portions of the U.S. and U.K. plans.

F-17

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

Pension expense for 2006,2005, and 2004 for these defined benefit plans consists of the followingcomponents:

| ** **                          | ** ** | **December 31,** | ** ** |
|-------------------------------------|------------|-----------------------|------------|
| ** **                          | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Service cost                        |       | $                     | 5,576      |   | $ | 4,516 |   | $ | 4,250 |   |
| Interest cost                       |       | 11,265                |       | 10,559 |   | 9,945 |   |
| Expected return  on plan assets     |       | (9,500                | )          | (8,226 | ) | (7,528 | ) |
| Amortization of  prior service cost |       | 122                   |       | 526 |   | 530 |   |
| Amortization of net  loss           |       | 3,095                 |       | 2,362 |   | 1,476 |   |
| Net periodic  pension expense       |       | $                     | 10,558     |   | $ | 9,737 |   | $ | 8,673 |   |

 

The Company incurred $1,551 of curtailment expense in2006 related to the LaSalle Factory pension plan as a result of the decision toclose the LaSalle plant. The curtailment expense is not included in the netperiodic pension expense disclosed above.

The Company expects to incur $107 and $2,933 foramortization of prior service cost and amortization of net loss in 2007.

F-18

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

Thefollowing table sets forth the plans’ funded status as of the respectivebalance sheet dates:

| ** **                                        | ** ** | **December 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|
| ** **                                        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Reconciliation of benefit  obligation:**        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Benefit obligation  at January 1             |       | $                     | (208,909   | ) | $ | (196,149 | ) |
| Service cost                                      |       | (5,576                | )          | (4,516 | ) |
| Interest cost                                     |       | (11,265               | )          | (10,559 | ) |
| Plan participant  contributions                   |       | (647                  | )          | (456 | ) |
| Plan amendments                                   |       | —                |       | (238 | ) |
| Actuarial loss                                    |       | (6,843                | )          | (16,217 | ) |
| Benefit payments                                  |       | 9,352                 |       | 8,696 |   |
| Effect of  exchange rate changes                  |       | (12,317               | )          | 10,530 |   |
| Benefit  obligation at December 31           |       | $                     | (236,205   | ) | $ | (208,909 | ) |
| **Reconciliation of fair value of  plan assets:** | ** ** | ** **            | ** ** | ** ** | ** ** |
| Fair value of  plan assets at January 1      |       | 134,379               |       | 116,138 |   |
| Actual return on  plan assets                     |       | 14,146                |       | 13,254 |   |
| Employer  contributions                           |       | 6,115                 |       | 15,963 |   |
| Effect of  exchange rate changes                  |       | 6,340                 |       | (4,221 | ) |
| Plan participant  contributions                   |       | 647                   |       | 456 |   |
| Benefit payments                                  |       | (7,747                | )          | (7,211 | ) |
| Fair value of  plan assets at December 31    |       | 153,880               |       | 134,379 |   |
| Funded status at  December 31                |       | (82,325               | )          | (74,530 | ) |
| Unrecognized  actuarial loss                      |       | —                |       | 46,233 |   |
| Unrecognized  prior service costs                 |       | —                |       | 1,511 |   |
| Net amount recognized                             |       | $                     | (82,325    | ) | $ | (26,786 | ) |

 

Amountsrecognized in the consolidated balance sheets as of:

| ** **                              | ** ** | **December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------|------------|
| ** **                              | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Long-term pension  liability, net (1)   |       | $                     | (80,380    | ) | $ | (37,549 | ) |
| Current pension  liability              |       | (1,945                | )          | (5,049 | ) |
| Intangible asset                        |       | —                |       | 1,665 |   |
| Accumulated other  comprehensive income |       | —                |       | 14,147 |   |
| Net amount recognized                   |       | $                     | (82,325    | ) | $ | (26,786 | ) |

----

(1)          Includes plan assets of$227 and $12,041 in 2006 and 2005, respectively for the U.K. plan that isincluded in other assets.

F-19

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

Amountsrecognized in accumulated other comprehensive income as of:

| ** **                            | ** ** | **December 31,** | ** ** |
|---------------------------------------|------------|-----------------------|------------|
| ** **                            | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Actuarial loss                        |       | $                     | 48,052     |   | $ | — |   |
| Prior Service  Cost                   |       | 1,183                 |       | — |   |
| Additional  minimum pension liability |       | —                |       | 14,147 |   |
|                                  |       | $                     | 49,235     |   | $ | 14,147 |   |

 

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

| ** **                                   | ** ** | **December 31,** | ** ** |
|----------------------------------------------|------------|-----------------------|------------|
| ** **                                   | ** ** | **2006**              | ** ** | **2005** | ** ** | **2004** | ** ** |
| Discount Rates                               |       |                  |       |   |   |   |   |
| United States                                |       | 6.00                  | %          | 5.75 | % | 6.00 | % |
| Germany                                      |       | 4.50                  |       | 4.50 |   | 4.75 |   |
| United Kingdom                               |       | 5.00                  |       | 4.66 |   | 5.25 |   |
| Rates of increase in  compensation levels    |       |                  |       |   |   |   |   |
| United States                                |       | 3.50                  |       | 3.50 |   | 3.50 |   |
| Germany                                      |       | 2.00                  |       | 2.00 |   | 2.50 |   |
| United Kingdom                               |       | 4.20                  |       | 3.90 |   | 4.00 |   |
| Expected long-term rate  of return on assets |       |                  |       |   |   |   |   |
| United States                                |       | 8.50                  |       | 8.50 |   | 8.50 |   |
| United Kingdom                               |       | 5.88                  |       | 5.86 |   | 6.20 |   |

 

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 equity securitiesrealize an average annual return of 11% and fixed income securities produce anaverage annual yield of 6%. The target asset allocation for the U.K. pensionassets, 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-20

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The weighted****average asset allocations by asset category for the U.S.and U.K. pension plans at December 31 are as follows:

| ** **        | ** ** | **U.S. Plan** | ** ** | **U.K. Plan** | ** ** |
|-------------------|------------|--------------------|------------|--------------------|------------|
| ** **        | ** ** | **2006**           | ** ** | **2005**           | ** ** | **2006** | ** ** | **2005** | ** ** |
| Equity securities |       |               | 66         | %                  |       |   | 62 | % |   |   | 50 | % |   |   | 48 | % |   |
| Debt securities   |       |               | 31         |               |       |   | 35 |   |   |   | 32 |   |   |   | 34 |   |   |
| Other             |       |               | 3          |               |       |   | 3 |   |   |   | 18 |   |   |   | 18 |   |   |
| Total             |       |               | 100        | %                  |       |   | 100 | % |   |   | 100 | % |   |   | 100 | % |   |

 

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

***Postretirement Benefits***

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.

Thecomponents of the postretirement benefit expense of the Company-sponsoredhealth benefit plans for 2006, 2005, and 2004, were as follows:

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service cost                    |       | $        | 595        |     | $          | 553      |       | $ | 621 |   |
| Interest cost                   |       | 2,016    |       | 1,876    |       | 1,753    |       |
| Net deferral and  amortization  |       | 762      |       | 693      |       | 543      |       |
| Postretirement benefit  expense |       | $        | 3,373      |     | $          | 3,122    |       | $ | 2,917 |   |

 

The Company expects to incur $923 for net deferral andamortization in 2007.

F-21

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (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,** | ** ** |
|-------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                        | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Reconciliation  of benefit obligation:**                        | ** ** | ** **            | ** ** | ** ** | ** ** |
| Accumulated postretirement  benefit liability at January 1   |       | $                     | (34,219    | ) | $ | (29,502 | ) |
| Service cost                                                      |       | (595                  | )          | (553 | ) |
| Interest cost                                                     |       | (2,016                | )          | (1,876 | ) |
| Actuarial loss                                                    |       | (3,615                | )          | (4,494 | ) |
| Benefit payments                                                  |       | 2,648                 |       | 2,206 |   |
| Accumulated  postretirement benefit liability at December 31 |       | (37,797               | )          | (34,219 | ) |
| **Reconciliation of fair value of plan assets:**                  | ** ** | ** **            | ** ** | ** ** | ** ** |
| Fair value of  plan assets at January 1                      |       | —                |       | — |   |
| Employer  contributions                                           |       | 2,648                 |       | 2,206 |   |
| Benefit payments                                                  |       | (2,648                | )          | (2,206 | ) |
| Fair value of  plan assets at December 31                    |       | —                |       | — |   |
| Funded status                                                     |       | (37,797               | )          | (34,219 | ) |
| Unrecognized  actuarial loss                                      |       | —                |       | 14,758 |   |
| Postretirement  benefit obligation                                |       | (37,797               | )          | (19,461 | ) |
| Less current  portion                                             |       | 2,604                 |       | — |   |
| Postretirement benefit  obligation, long-term                     |       | $                     | (35,193    | ) | $ | (19,461 | ) |

 

At December 31, 2006 thereis $17,610 of actuarial loss recognized in accumulated other comprehensiveincome.

The assumedweighted average annual rate of increase in the per capita cost of medicalbenefits is 10.0% for 2007 and is assumed to decrease ratably in 2008 through2012 and remain level at 4.5% thereafter.

U.S. employeesretiring after March 1, 1993, and hired prior to January 1, 1993,will receive the standard health benefits up to age 65 and then will beeligible for a Medicare reimbursement allowance based on years of service. U.S.employees hired after January 1, 1993, and retiring after age 65 with tenyears of service, will be eligible 65 for a Medicare reimbursement allowancebased on years of service.

A one percent increase or decrease in the annual healthcare trend rates would have increased or decreased the accumulatedpostretirement benefit obligation at December 31, 2006, by $2,418, andincreased or decreased postretirement benefit expense for 2006 by $209. Theweighted average discount rate used to estimate the accumulated postretirementbenefit obligation was 6.0%, 5.75%, and 6.0%, for 2006, 2005, and 2004,respectively.

F-22

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

Thebenefits expected to be paid from the benefit plans, which reflect expectedfuture years of service, and the Medicare subsidy expected to be received areas follows:

| ** ** | ** ** | **Pensions** | ** ** | **Health Care** | ** ** | **Health Care  subsidy receipts (1)** | ** ** |
|------------|------------|--------------|------------|----------------------|------------|------------------------------------------------------|------------|
| 2007       |       | $            | 7,409      |                 |       | $                                                    | 2,681      |   |   |   | $ | 78 |   |   |
| 2008       |       | 8,086        |       |                 | 2,945      |                                                 |       |   | 98 |   |   |
| 2009       |       | 8,821        |       |                 | 3,223      |                                                 |       |   | 118 |   |   |
| 2010       |       | 9,649        |       |                 | 3,497      |                                                 |       |   | 141 |   |   |
| 2011       |       | 10,400       |       |                 | 3,853      |                                                 |       |   | 154 |   |   |
| 2012-2016  |       | 64,919       |       |                 | 20,926     |                                                 |       |   | 1,210 |   |   |
|            |            |              |            |                      |            |                                                      |            |  |  |  |  |  |  |  |

----

(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 $6,100to the Company pension and health benefit plans in 2007.

TheCompany also maintains two defined contribution plans, the Sauer-DanfossEmployees’ Savings Plan and the Sauer-Danfoss LaSalle Factory Employee SavingsPlan, for eligible employees. Company contributions include both base andmatching amounts. The Company contributed approximately $2,500, $2,200 and$1,900 to these plans in 2006, 2005 and 2004, respectively.

**(9) Income Taxes:**

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

| ** **          | ** ** | **Years Ended December 31,** | ** ** |
|---------------------|------------|---------------------------------------------|------------|
| ** **          | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| United States       |       | $                                           | 6,519      |   | $ | 5,790 |   | $ | (4,973 | ) |
| European and  other |       | 64,501                                      |       | 43,917 |   | 53,894 |   |
| Total               |       | $                                           | 71,020     |   | $ | 49,707 |   | $ | 48,921 |   |

 

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-23

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The expense for incometaxes by taxing jurisdiction is as follows:

| ** **               | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------|------------|---------------------------------------------|------------|
| ** **               | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current                  |       |                                        |       |   |   |   |   |
| United States            |       |                                        |       |   |   |   |   |
| Federal                  |       | $                                           | 585        |   | $ | (414 | ) | $ | 2,411 |   |
| State                    |       | (446                                        | )          | 357 |   | (100 | ) |
| European and other       |       | (23,373                                     | )          | (23,722 | ) | (21,294 | ) |
| Total Current            |       | (23,234                                     | )          | (23,779 | ) | (18,983 | ) |
| Deferred                 |       |                                        |       |   |   |   |   |
| United States            |       |                                        |       |   |   |   |   |
| Federal                  |       | 3,070                                       |       | 7,594 |   | 3,130 |   |
| State                    |       | 1,165                                       |       | 252 |   | (563 | ) |
| European and other       |       | 1,727                                       |       | 4,941 |   | 681 |   |
| Total Deferred           |       | 5,962                                       |       | 12,787 |   | 3,248 |   |
| Total income tax expense |       | $                                           | (17,272    | ) | $ | (10,992 | ) | $ | (15,735 | ) |

 

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

| ** **                                                                         | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                                                         | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Tax expense based  on U.S. statutory tax rate                                      |       | $                                           | (24,857    | ) | $ | (17,398 | ) | $ | (17,124 | ) |
| Deferred tax  benefit not previously recognized                                    |       | 5,660                                       |       | 4,355 |   | — |   |
| 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                         |       | (1,199                                      | )          | (627 | ) | (1,435 | ) |
| Taxes on non-U.S.  locations’ income at rates which differ from the U.S. rate |       | 4,385                                       |       | 2,690 |   | 3,806 |   |
| State income  taxes                                                                |       | 467                                         |       | 396 |   | (431 | ) |
| Tax effect of  minority interest                                                   |       | (1,752                                      | )          | (914 | ) | (900 | ) |
| Other                                                                              |       | 24                                          |       | (276 | ) | (2,502 | ) |
| Total income tax  expense                                                          |       | $                                           | (17,272    | ) | $ | (10,992 | ) | $ | (15,735 | ) |

 

F-24

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The components of theCompany’s net deferred tax assets and liabilities, determined on ajurisdictional and entity basis, are attributable to the following:

| ** **                                                                   | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                   | ** ** | **2006**              | ** ** | **2005** | ** ** |
| ** **                                                                   | ** ** | **Assets**            | ** ** | **Liabilities** | ** ** | **Assets** | ** ** | **Liabilities** | ** ** |
| Net operating  loss (NOL) and tax credit carryforwards                       |       | $                     | 27,414     |   | $ | — |   | $ | 26,122 |   | $ | — |   |
| Deferred  compensation, post-retirement medical and accrued pension benefits |       | 35,415                |       | — |   | 20,996 |   | (953 | ) |
| Fixed asset basis  differences                                               |       | 6,230                 |       | (27,477 | ) | 7,250 |   | (30,688 | ) |
| Inventory and  warranty accruals                                             |       | 6,660                 |       | (1,577 | ) | 10,177 |   | (1,958 | ) |
| Intangible asset  fair market value step-up                                  |       | 6,199                 |       | (1,194 | ) | 10,748 |   | (10,909 | ) |
| Other items                                                                  |       | 9,879                 |       | (2,944 | ) | 11,658 |   | (4,060 | ) |
| Gross deferred  tax assets/liabilities                                       |       | 91,797                |       | (33,192 | ) | 86,951 |   | (48,568 | ) |
| Valuation  allowance                                                         |       | (15,440               | )          | — |   | (30,808 | ) | — |   |
| Net deferred tax  assets/liabilities                                         |       | 76,357                |       | (33,192 | ) | 56,143 |   | (48,568 | ) |
| Less current  portion                                                        |       | (18,140               | )          | 2,602 |   | (13,272 | ) | 4,291 |   |
| Net deferred tax  assets/liabilities, long-term                              |       | $                     | 58,217     |   | $ | (30,590 | ) | $ | 42,871 |   | $ | (44,277 | ) |

 

In 2006 the company determined that unrecognized taxbenefit of tax credits would be realized in the U.S. As a result $5,660 invaluation allowance was reversed and tax expense was reduced. Also in 2006 thecompany determined that most of the US NOL carryforward will offset futuretaxable income. This resulted in a decrease to the valuation allowance of $16,533and a corresponding decrease to goodwill. This NOL was acquired in 2000 relatedto the merger with Danfoss Fluid Power and is subject to annual limits underIRC section 382. The remaining valuation allowance relates primarily to Germandeferred tax assets in excess of the German NOL-National noted below and an NOLin the U.K. which management has determined is not likely to be recognized inthe future. To the extent the unrecognized tax benefit is recognized in thefuture, the tax benefit will reduce tax expense.

As of December 31, 2006 and 2005, the Company hadnot provided U.S. federal income taxes on $149,143, and $122,934 ofundistributed earnings recorded by certain subsidiaries outside the UnitedStates since these earnings were deemed permanently invested. Although it isnot practicable to determine the deferred tax liability on the unremittedearnings, foreign tax credits would be available to reduce U.S. tax liabilityif these foreign earnings were remitted.

F-25

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

TheCompany had the following tax return carryforwards available to offset futureyears’ taxable income at December 31, 2006:

| ** **                                            | ** ** | **Amount** | ** ** | **Expiration Dates** | ** ** |
|-------------------------------------------------------|------------|------------|------------|---------------------------|------------|
| German NOL —  National                      |       | $          | 56,955     |                      |       | None |   |   |
| German NOL —  Local                         |       | 5,979      |       |                      | None       |   |   |
| U.S. NOL                                              |       | 24,469     |       |                      | 2010-2019  |   |   |
| U.K. NOL                                              |       | 8,368      |       |                      | None       |   |   |
| Other non-U.S.  NOL                                   |       | 1,516      |       |                      | Various    |   |   |
| State NOL                                             |       | 17,884     |       |                      | Various    |   |   |
| Foreign tax  credits (available to offset U.S. taxes) |       | 10,858     |       |                      | 2011-2015  |   |   |
| State tax credits                                     |       | 2,577      |       |                      | Various    |   |   |
| US general business tax  credits                      |       | 1,908      |       |                      | 2022-2026  |   |   |
|                                                       |            |            |            |                           |            |  |  |  |

 

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 $16,600. 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, 2006.

The American Jobs Creation Act of 2004 introduced alimited time 85% dividends received deduction on the repatriation of certainforeign earnings to a U.S. taxpayer, provided certain criteria are met. During2005 the company recognized a tax expense of $829 related to repatriation offoreign earnings under this provision.

TheCompany’s resolved the IRS audit of its federal income tax returns for years1997 through 2001 during 2005. The Company reduced its expense for income taxesby $335 in 2005 to reflect the final settlement.

**(10)** MinorityInterests:

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

a)               A 40% minorityinterest held by Agri-Fab, Inc. in Hydro-Gear Limited Partnership, a U.S.limited partnership, for 2006, 2005, and 2004.

b)              A 40% minorityinterest held by Shanghai Hydraulics and Pneumatics in Sauer Shanghai HydraulicTransmission Co., Ltd., a Chinese equity business venture for 2006,2005, and 2004.

F-26

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

c)               A 35% minorityinterest held by Daikin Industries Ltd. inSauer-Danfoss-Daikin, Ltd., a Japanese corporation, for 2006, 2005, and2004.

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

d)              A 49.9% minorityinterest held by Topcon Laser Systems in TSD Integrated Controls LLC, aU.S. limited partnership, for 2006, 2005, and 2004.

e)               A 55% minority interest held by DaikinIndustries Ltd. in Daikin-Sauer-Danfoss Manufacturing, Ltd., aJapanese corporation, for 2006, 2005 and 2004.

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

Thefollowing table sets forth the components of minority interest in theconsolidated balance sheets:

| ** **                                           | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|-----------------------|------------|
| ** **                                           | ** ** | **2006**              | ** ** | **2005** | ** ** |
| Hydro-Gear  Limited Partnership                      |       | $                     | 29,938     |   | $ | 33,586 |   |
| Sauer Shanghai  Hydraulic Transmission Co., Ltd |       | 5,552                 |       | 4,357 |   |
| Sauer-Danfoss-Daikin,  Ltd                           |       | 9,725                 |       | 7,765 |   |
| TSD Integrated Controls LLC                     |       | 1,834                 |       | 847 |   |
| Daikin-Sauer-Danfoss  Manufacturing, Ltd.       |       | 6,399                 |       | 4,885 |   |
| Total                                                |       | $                     | 53,448     |   | $ | 51,440 |   |

 

TheHydro-Gear Limited Partnership agreement indicates a termination date of December 31,2035. This entity is consolidated in the Company’s financial statements. Theagreement indicates that if the partnership were to terminate the partnershipwould be liquidated and the resulting proceeds would be distributed inaccordance with each partner’s ownership percentage.

F-27

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

**(11)** AccumulatedOther Comprehensive Income:

Thechanges in accumulated other comprehensive income for the years ended December 31,2004, 2005, and 2006 follows:

| ** **                            | ** ** | **Currency  Translation** | ** ** | **Pension /  Postretirement  Benefit Adjustment** | ** ** | **Hedging  Activities** | ** ** | **Accumulated  Other  Comprehensive  Income** | ** ** |
|---------------------------------------|------------|---------------------------|------------|-------------------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------|------------|
| Balance as of  January 1, 2004   |       |                      | $          | 41,299                                                      |       |                    |       | $                                             | (3,990     | ) |   |   | $ | 67 |   |   |   | $ | 37,376 |   |   |
| Change in period                      |       |                      | 32,527     |                                                        |       |                    | (9,331     | )                                             |       |   | (674 | ) |   |   | 22,522 |   |   |
| Effect of  exchange rate changes      |       |                      | —     |                                                        |       |                    | (127       | )                                             |       |   | — |   |   |   | (127 | ) |   |
| 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    | )                                                           |       |                    | 88         |                                          |       |   | 301 |   |   |   | (34,195 | ) |   |
| Effect of  exchange rate changes      |       |                      | —     |                                                        |       |                    | 699        |                                          |       |   | — |   |   |   | 699 |   |   |
| Income tax  expense                   |       |                      | —     |                                                        |       |                    | (695       | )(1)                                          |       |   | (109 | ) |   |   | (804 | ) |   |
| Balance as of  December 31, 2005 |       |                      | 39,242     |                                                        |       |                    | (11,553    | )                                             |       |   | (279 | ) |   |   | 27,410 |   |   |
| Change in period                      |       |                      | 38,089     |                                                        |       |                    | (51,800    | )                                             |       |   | 1,145 |   |   |   | (12,566 | ) |   |
| Effect of  exchange rate changes      |       |                      | —     |                                                        |       |                    | (817       | )                                             |       |   | — |   |   |   | (817 | ) |   |
| Income tax  benefit (expense)         |       |                      | —     |                                                        |       |                    | 12,361     |                                          |       |   | (298 | ) |   |   | 12,063 |   |   |
| Balance as of  December 31, 2006 |       |                      | $          | 77,331                                                      |       |                    |       | $                                             | (51,809    | ) |   |   | $ | 568 |   |   |   | $ | 26,090 |   |   |

----

(1)          Representstax effect on German pension amounts, not previously tax-effected related tonet operating loss carryforwards.

**(12)** DerivativeFinancial Instruments:

The Company recognizes all derivative financialinstruments, including foreign exchange contracts and interest rate swaps, inthe consolidated financial statements at fair value in accordance with SFAS No. 133.

In 2005 the Company began to enter into forwardcontracts to hedge the value of the U.S. dollar cash flow at locations that donot have the U.S. dollar as their functional currency but conduct certaintransactions in U.S. dollars. The objective of all outstanding forwardcontracts is to hedge forecasted transactions in U.S. dollars through the cashsettlement date. The Company enters forward contracts that mature from two toeighteen 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. The fair value estimates used to value the foreignexchange contracts are based on information available to management and weredetermined using quoted market prices and the discounted value of future cashflows.

Changes in fair values of derivatives that areaccounted for as cash flow hedges are recorded in other comprehensive income.Any portion of the hedge that is deemed ineffective due to the absolute valueof 

F-28

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

**(12)** Derivative Financial Instruments: (Continued)

the cumulative change inthe derivative being greater than the cumulative change in the hedged item isrecorded immediately in other income (expense) on the consolidated statement ofincome. There was no hedge ineffectiveness in 2006 or 2005.

During the year ended December 31, 2006 theCompany recognized an increase in net sales of $483 due to the effects of hedgeaccounting for forward contracts. In addition, the Company recognizedadditional other expense of $327 as a result of the forward contracts.

At December 31, 2006 the Company expects toreclassify $643 of gains, net of tax, on derivative instruments from accumulatedother comprehensive income to earnings during the next twelve months due to theactual fulfillment of forecasted transactions.

Interestrate swaps, which are designated as cash flow hedges, are used by the Companyto establish fixed interest rates on outstanding borrowings. At December 31,2006 and 2005, the Company had three interest rate swaps outstanding thatmature at various dates through March 2009. The combined notional amountof the three contracts was 4,686 and 6,769 euros at December 31, 2006 and2005, respectively. There is no ineffectiveness of the interest rate swaps andtherefore, the changes in fair value of the derivatives of $74 and $221, net ofdeferred taxes, were recorded in accumulated other comprehensive income at December 31,2006 and 2005, respectively.

**(13)** Long-TermIncentive Plan:

The Company’s 1998 Long-Term Incentive Plan (1998Incentive Plan) provides for the grant of stock options, stock appreciationrights, restricted stock, performance units, performance shares, and otherincentive awards to officers and key employees. The total number of shares ofcommon stock that may be subject to awards or be issued under the 1998Incentive Plan shall not exceed 2,400,000 shares, of which no more than1,200,000 shares may be issued as restricted stock. The settlement ofperformance units is in shares of company stock or cash as determined by theCompensation Committee of the Board of Directors. The performance units entitlethe participants to receive an amount equal to the Company’s dividends duringthe vesting period.

In December 2005 the Board of Directors approvedthe adoption of the Sauer-Danfoss Inc. 2006 Omnibus Incentive Plan (2006Incentive Plan), which was approved by the stockholders at the annual meetingin June 2006. The 2006 Incentive Plan provides for grants similar to thoseunder the 1998 Incentive Plan and qualifies certain awards for theperformance-based exception to obtain favorable tax treatment. The total numberof shares of common stock that may be issued under the 2006 Incentive Planshall not exceed 3,500,000 shares. In February 2006 the CompensationCommittee granted 346,013 performance units under the 2006 Incentive Plan,260,862 of which would be settled 100% in company stock with shares withheldhaving a value to meet the minimum statutory withholding requirements and85,151 performance units granted to certain individuals that would be settledas cash. The units to be settled in cash are accounted for as liability units,with the remainder of the units accounted for as equity units.

F-29

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The following chartsummarizes performance unit activity under the Plan for the year ended December 31,2006:

| ** **                             | ** ** | **Number** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** | **Weighted Average  Vesting Period  in Years** | ** ** |
|----------------------------------------|------------|------------|------------|-------------------------------------------------------------|------------|---------------------------------------------------------------|------------|
| Units Outstanding  at January 1   |       | 948,029    |       |                                                        | $          | 18.42                                                         |       |   |   | 2.8 |   |   |
| Units settled                          |       | (257,164   | )          |                                                        | 16.98      |                                                          |       |   | 2.0 |   |   |
| Units granted                          |       | 260,862    |       |                                                        | 25.93      |                                                          |       |   | 3.0 |   |   |
| Units forefeited                       |       | (17,033    | )          |                                                        | 21.74      |                                                          |       |   | 3.0 |   |   |
| Units Outstanding at  December 31 |       | 934,694    |       |                                                        | 20.85      |                                                          |       |   | 3.0 |   |   |

 

| **Cash Units**                    | ** ** | ** ** | ** ** | **Number** | ** ** | **Fair Value** | ** ** | **Weighted Average  Vesting Period  in Years** | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|---------------------|------------|---------------------------------------------------------------|------------|
| Units Outstanding  at January 1   |       |       | —     |       |       |                | —     |                                                          |       |   | — |   |   |
| Units granted                          |       |       | 85,151     |       |       |                | $          | 32.25                                                         |       |   |   | 3.0 |   |   |
| Units Outstanding at  December 31 |       |       | 85,151     |       |       |                | $          | 32.25                                                         |       |   |   | 3.0 |   |   |

 

The Compensation Committeesets performance goals for each performance unit grant and depending on theextent to which these goals are met will determine the number of performanceunits that will be paid out to the participants. Based on performance resultsfor 2004 through 2006 the performance units granted in 2004 are expected to besettled at 190% or the equivalent of approximately 700,000 shares.

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 2004 theBoard of Directors approved granting approximately 323,000 performance unitsunder the 1998 Incentive Plan to replace all performance units and stockoptions previously granted, as the original targets established for thosegrants were no longer deemed reasonable due to unforeseen economic conditions.In addition, on that date, the Board of Directors approved grantingapproximately 385,000 additional performance units under the 1998 IncentivePlan. In 2004 compensation cost related to the units to be distributed incompany stock and in cash had been recognized based on the fair value of theequity instruments at the performance unit grant date and fair value at December 31,2004, respectively.

F-30

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

**(13)** Long-TermIncentive Plan: (Continued)

In accordance with SFAS No. 123R, “Share-BasedPayment,” compensation expense is recognized over the vesting period of threeyears, measured based on the market price of the Company’s stock at the date ofgrant or modification, with an offsetting increase in additional paid-incapital. The expense related to the performance units granted under the 2006Incentive Plan was based on the market price of the Company’s stock as of June 1,2006, the time the 2006 Incentive Plan was approved by the Company’sstockholders. The expense related to the grants that will be settled in cash isbased on the market price of the Company’s stock as of the balance sheet date.Compensation expense recognized in selling, general, and administrativeexpenses in conjunction with the performance units outstanding was $6,827,$9,499, and $10,458 in 2006, 2005, and 2004, respectively. The tax benefitsrecognized related to this expense was $2,468, $3,506, and $4,125 in 2006,2005, and 2004, respectively. The Company expects to recognize approximately$10,800 of additional expense through 2008 related to the outstandingperformance units under these two plans.

The Company also has a Non-employee Director StockOption and Restricted Stock Plan which permits the granting of non-qualifiedstock options and restricted common stock to directors of the Company who arenot employees of the Company. The total number of shares of common stock to beissued under this plan shall not exceed 250,000 shares.

Underthe Non-employee Director Stock Option and Restricted Stock Plan the Companyawarded, 13,500 shares of restricted stock to non-employee directors in2006, 2005, and 2004. The restricted stock awards entitle the participants tofull dividend and voting rights. Unvested shares are restricted as todisposition and subject to forfeiture under certain circumstances. The value ofeach award was established based on the market value of the stock as of thegrant date. The shares 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 2006, 2005, and 2004 amounted to $243, $184, and $128,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 paidon a monthly basis. Total expense recognized for goods and services purchasedfrom Danfoss A/S for 2006, 2005, and 2004 was approximately $63,400, $52,900,and $51,800, respectively. At December 31, 2006 and 2005 approximately$10,700 and $8,000 owed to Danfoss A/S is included in accounts payable onthe consolidated balance sheet. Payments required under these agreements as of December 31,2006, during the years ending 2007 though 2011 and 2012 and thereafter, are$7,583, $7,582, $7,580, $7,588, $7,597, and $17,029, respectively.

F-31

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

The Company purchases inventory components fromShanghai Hydraulics and Pneumatics, a minority interest owner in an entityincluded in the Company’s consolidated financial statements. Purchases wereapproximately $3,200, $3,300, and, $2,600 in 2006, 2005, and 2004,respectively.

In addition, the Company sold product totalingapproximately $4,600, $5,400 and $6,000 in 2006, 2005, and 2004, respectively,to Daikin Industries Ltd. (Daikin), a minority interest owner in an entityconsolidated by the Company. The Company also purchases inventory componentsand ongoing operational services from Daikin. These services include sharedfacilities and administrative support. Total expense recognized for goods andservices purchased from Daikin in 2006, 2005, and 2004 were approximately$5,900, $6,600 and $6,900, respectively.

TheCompany had advertising expense of $150 in 2004 to sponsor a competitivesailing yacht owned by a director of the Company. In 2005 the Company alsocontributed $350 to a science park principally sponsored by a shareholder ofDanfoss A/S. In addition, the Company had sales to Faun Umwelttechnik GmbH & Co.,a company owned by a director, of $1,200, $900 and $800 in 2006, 2005 and 2004,respectively.

**(15)** Commitments, Contingencies, andGuarantees:

The Company leases certain facilities and equipmentunder operating leases, many of which contain renewal options. Total rentalexpense on all operating leases during 2006, 2005, and, 2004 was $18,490, $16,429,and $17,678, respectively. Rent is expensed on a straight-line basis over theterm of the leases.

Minimum future rental commitments under allnoncancelable operating leases as of December 31, 2006, during the yearsending 2007 through 2011 and for 2012 and thereafter, are $10,956, $8,819,$6,730, $3,517, $1,496, and $22,871, respectively.

The Company also leases certain facilities andequipment under capital leases. The liability related to these capital leasesis included in current other accrued liabilities and other long-termliabilities on the consolidated balance sheets. Minimum future lease paymentsunder all noncancelable capital leases as of December 31, 2006, during theyears ending 2007 through 2011 and for 2012 and thereafter, are $1,131, $1,139,$1,129, $999, $876, and $13,802, respectively.

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

F-32

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

**(16)** QuarterlyFinancial Data (Unaudited):

Summarizedquarterly data is set forth in the following table:

| ** **                                              | ** ** | **Quarter** | ** ** |
|---------------------------------------------------------|------------|-------------|------------|
| ** **                                              | ** ** | **First**   | ** ** | **Second** | ** ** | **Third** | ** ** | **Fourth** | ** ** | **Total** | ** ** |
| **2006**                                                |       |        |       |   |   |   |   |   |   |   |   |
| Net sales                                               |       | $           | 483,959    |   | $ | 469,856 |   | $ | 381,895 |   | $ | 403,378 |   | $ | 1,739,088 |   |
| Gross profit                                            |       | 115,972     |       | 118,475 |   | 82,500 |   | 79,817 |   | 396,764 |   |
| Net income (loss)                                       |       | 25,221      |       | 23,510 |   | 7,078 |   | (2,061 | ) | 53,748 |   |
| Basic net income  (loss) per common share (1)           |       | $           | 0.54       |   | $ | 0.49 |   | $ | 0.15 |   | $ | (0.04 | ) | $ | 1.13 |   |
| Diluted net income  (loss) per common share (1)         |       | $           | 0.54       |   | $ | 0.49 |   | $ | 0.15 |   | $ | (0.04 | ) | $ | 1.11 |   |
| **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 |   |

----

(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)** Segmentand Geographic Information:

The Company reports itsoperating segments around its various product lines of Propel, Work Functionand 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 motors,and valves that control and direct the power of a vehicle. Segment costs inGlobal Services relate to internal global service departments and include costssuch as consulting for special projects, tax and accounting fees paid tooutside third parties, certain insurance premiums, and amortization ofintangible assets from certain business combinations.

F-33

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**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

Theaccounting policies of the segments are the same as those described in thesummary of significant accounting policies. The Company evaluates individualsegment performance based on segment income or loss defined as the respectivesegment’s portion of the total Company’s net income, excluding net interestexpense, income taxes, minority interest, and equity in net earnings ofaffiliates. The following table presents the significant items by operating segmentfor the results of operations for the years ended December 31, 2006, 2005,and 2004, respectively:

| ** **                     | ** ** | **Propel** | ** ** | **Work  Function** | ** ** | **Controls** | ** ** | **Global  Services** | ** ** | **Total**  | ** ** |
|--------------------------------|------------|------------|------------|--------------------|------------|--------------|------------|----------------------|------------|------------|------------|
| **2006**                       | ** ** | ** ** | ** ** | ** **         | ** ** | ** **   | ** ** | ** **           | ** ** | ** ** | ** ** |
| Trade sales                    |       | $          | 839,306    |               | $          | 471,379      |       | $                    | 428,403    |       | $          | — |   | $ | 1,739,088 |   |
| Segment income  (loss)         |       | 111,762    |       | 16,509             |       | 42,680       |       | (60,553              | )          | 110,398    |       |
| Interest expense               |       |       |       |               |       |         |       |                 |       | (18,415    | )          |
| Interest income                |       |       |       |               |       |         |       |                 |       | 654        |       |
| Minority interest              |       |       |       |               |       |         |       |                 |       | (21,617    | )          |
| Income before  income taxes    |       |       |       |               |       |         |       |                 |       | 71,020     |       |
| Depreciation and  amortization |       | 42,822     |       | 29,190             |       | 18,399       |       | 5,254                |       | 95,665     |       |
| Total assets                   |       | 405,847    |       | 335,843            |       | 242,724      |       | 324,741              |       | 1,309,155  |       |
| Capital  expenditures          |       | 42,934     |       | 39,050             |       | 29,393       |       | 4,867                |       | 116,244    |       |
| **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              |       |       |       |               |       |         |       |                 |       | (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              |       |       |       |               |       |         |       |                 |       | (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     |       |

 

F-34

----

**Sauer-Danfoss Inc. and Subsidiaries Notes to Consolidated Financial Statements (Continued) December 31, 2006, 2005, and 2004 (Dollars in thousands, except per share data)**

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

A summary of the Company’snet sales and long-lived assets by geographic area is presented below:

| ** **      | ** ** | **Net Sales (1)** | ** ** | **Long-Lived Assets (2)** | ** ** |
|-----------------|------------|-----------------------------|------------|-------------------------------------|------------|
| ** **      | ** ** | **2006**                    | ** ** | **2005**                            | ** ** | **2004** | ** ** | **2006** | ** ** | **2005** | ** ** |
| United States   |       | $                           | 734,844    |                                | $          | 679,849 |   | $ | 598,007 |   | $ | 181,242 |   | $ | 174,201 |   |
| Germany         |       | 166,756                     |       | 145,521                             |       | 134,513 |   | 64,743 |   | 56,687 |   |
| Italy           |       | 118,334                     |       | 100,641                             |       | 100,072 |   | 31,892 |   | 28,222 |   |
| Denmark (3)     |       | 19,362                      |       | 22,747                              |       | 22,187 |   | 192,271 |   | 188,109 |   |
| Other countries |       | 699,792                     |       | 599,058                             |       | 549,380 |   | 175,485 |   | 168,603 |   |
| Total           |       | $                           | 1,739,088  |                                | $          | 1,547,816 |   | $ | 1,404,159 |   | $ | 645,633 |   | $ | 615,822 |   |

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

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

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

No single customer accounted for 10% or more of totalconsolidated sales in any year presented.

F-35

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**Report ofManagement**

**Management Oversight**

Sauer-Danfoss believesthat good corporate governance promotes ethical business practices, demandsmeticulous accounting policies and procedures, and includes a structure witheffective checks and balances. The management of Sauer-Danfoss Inc. isresponsible for the integrity and objectivity of the financial informationpresented in this annual report on Form 10-K. Sauer-Danfoss believesthat the consolidated financial statements have been prepared in conformity withaccounting principles generally accepted in the United States applying certainestimates and judgments as required.

Our management isresponsible for establishing and maintaining a system of internal controls overfinancial reporting. This system is augmented by written policies andprocedures, careful selection and training of financial management personnel, acontinuing management commitment to the integrity of the system, and throughexaminations by an internal audit function that coordinates its activities withthe 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, 2006.

**Independent Oversight**

All of our directors areskilled business leaders. The members of the Board and each committee haveexpress authority to retain outside advisors. The Board and each committeeperform annual self-evaluations in order to assess their performance and toensure that the Board and committee structure is providing effective oversightof corporate management.

Our Audit Committee iscomposed entirely of independent outside directors. The Committee meetsperiodically with management, the internal auditors, and the independentauditors, both separately and jointly, to discuss internal accounting controlsand the quality of financial reporting. To ensure complete independence, theinternal auditors and representatives of KPMG LLP have full access to meetwith the Audit Committee, with or without management representatives present,to discuss the results of their audits and their opinions on the adequacy ofinternal controls and the quality of financial reporting. The Audit Committeehas the direct responsibility for the appointment of the independent registeredaccounting firm to be retained for the coming year, subject to stockholderapproval.

**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-36

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**Code of Legal andEthical 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 in 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-37

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**Report ofIndependent Registered Public Accounting Firm**

To the Shareholders of Sauer-Danfoss Inc.:

We have audited the accompanying consolidated balancesheets of Sauer-Danfoss Inc. and subsidiaries (the Company) as of December 31,2006 and 2005, 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, 2006. These consolidated financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these consolidated financialstatements based on our audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audits to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

In our opinion, the consolidated financial statementsreferred to above present fairly, in all material respects, the financialposition of Sauer-Danfoss Inc. and subsidiaries as of December 31,2006 and 2005, and the results of their operations and their cash flows foreach of the years in the three-year period ended December 31, 2006,in conformity with U.S. generally accepted accounting principles.

As disclosed in Notes 1 and 8 to the consolidatedfinancial statements, the Company adopted the provisions of Statement of FinancialAccounting Standards No. 158, *Employers’ Accounting forDefined Benefit Pension and other Postretirement Plans*, onDecember 31, 2006.

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, 2006, 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 12, 2007, expressed an unqualifiedopinion on management’s assessment of, and effective operations of, internalcontrol over financial reporting.

/s/ KPMG LLP

Des Moines, IowaMarch 12, 2007

F-38

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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, thatSauer-Danfoss Inc. (a Delaware corporation) and subsidiaries (the Company)maintained effective internal control over financial reporting as of December 31,2006, 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 thepolicies or procedures may deteriorate.

In our opinion, management’sassessment that Sauer-Danfoss Inc. and subsidiaries maintained effectiveinternal control over financial reporting as of December 31, 2006, 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, 2006, basedon criteria established in *Internal Control — IntegratedFramework* issued by the Committee of Sponsoring Organizations of theTreadway Commission (COSO).

F-39

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We also have audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the consolidated balance sheets of Sauer-Danfoss Inc. andsubsidiaries as of December 31, 2006 and 2005, and the relatedconsolidated statements of income, stockholders’ equity and comprehensiveincome and cash flows for each of the years in the three-year period ended December 31, 2006,and our report dated March 12, 2007 expressed an unqualified opinion onthose consolidated financial statements.

/s/ KPMG LLP

Des Moines, IowaMarch 12, 2007

F-40

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**Schedule IISauer-Danfoss Inc. and SubsidiariesValuation and Qualifying AccountsYears Ended December 31, 2004, 2005, and 2006(in thousands)**

 

| ** **                                  | ** ** | **Balance at  Beginning of  Year** | ** ** | **Charged to  Costs and  Expenses** | ** ** | **Receivables  Written Off/  Settlement  of Claims** | ** ** | **Foreign  Currency  Translation  Adjustment** | ** ** | **Balance at  End of  Year** | ** ** |
|---------------------------------------------|------------|----------------------------------------------|------------|-----------------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------------------|------------|----------------------------------------|------------|
| 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 |   |   |
| For the year  ended  December 31, 2006 |       |                                         |       |                                          |       |                                                           |       |                                           |       |                                   |       |   |   |   |   |   |   |   |   |   |   |
| Allowance for doubtful  accounts            |       |                                         | $          | 4,900                                         |       |                                                           |       | 1,140                                          |       |                                   |       | (613 | ) |   |   | 278 |   |   |   | $ | 5,705 |   |   |

 

F-41

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**Report ofIndependent Registered Public Accounting Firm on Financial Statement Schedule**

To the Shareholders of Sauer-Danfoss Inc.:

Under date of March 12, 2007, we reported on theconsolidated balance sheets of Sauer-Danfoss Inc. and subsidiaries as of December 31,2006 and 2005, 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, 2006, 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.This financial statement schedule is the responsibility of the Company’smanagement. Our responsibility is to express an opinion on the financialstatement schedule based on our audits.

In our opinion, the financial statement schedule, whenconsidered in relation to the 2006, 2005, and 2004 basic consolidated financialstatements taken as a whole, presents fairly, in all material respects, theinformation set forth therein.

Our report dated March 12, 2007, notes that theCompany adopted the provisions of Statement of Financial Accounting StandardsNo. 158, *Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans*, on December 31, 2006.

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, 2006, 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 12, 2007, expressed an unqualifiedopinion on management’s assessment of, and effective operation of, internalcontrol over financial reporting.

/s/ KPMG LLP

Des Moines, IowaMarch 12, 2007

F-42

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