Management’s Discussion and Analysis  of Financial Condition and Results of Operations 26 BorgWarner Inc.  and Consolidated Subsidiaries 27 The  Engine  segment 2004 net sales increased 18.6% over 2003 and  EBIT increased 17.6% over the same period. This segment benefited  from strong demand for the Company’s turbochargers for European  passenger cars and commercial vehicles. The segment EBIT was  impacted by increased volume, productivity and positive currency  impact, which offset commodity price increases of approximately  $20 million and start up costs in Korea and China.  Gross Profit  for 2004 was 18.5% down from 19.1% in 2003 and down  from 20.3% in 2002. The decrease in gross profit in 2004 was due  to several factors, including significant commodity price increases,  including steel, a change in sales mix and geographic expansion.  The geographic expansion includes new facilities in Europe and Asia  for both operating segments. We anticipate 2005 margins to be  impacted by the leveling off of commodity price increases, the con- tinued shift from components to systems sales and continued results  from our cost reduction initiatives.  The Engine segment 2003 net sales increased 13.4% over 2002 and  EBIT increased 11.0% over the same period. This segment benefited  from continued demand for the Company’s turbochargers for European  passenger cars and commercial vehicles as well as continued growth  of our timing chain and emissions products. The EBIT was impacted  by increased productivity and production in the turbocharger business,  which translated into higher profitability. This was partially offset by  start up costs for Variable Cam Timing systems, which will launch in  2004 and for new Korean operations. Also impacting gross margins in 2004, 2003 and 2002 is the effect  of a royalty agreement the Company entered into with Honeywell  International for certain variable turbine geometry (VTG) turbocharg- ers after a German court ruled in favor of Honeywell in a patent  infringement action. In order to continue shipping to its OEM custom- ers, the Company and Honeywell entered into two separate royalty  agreements, signed in July 2002 and June 2003, respectively. The  June 2003 agreement runs through 2006 with a minimum royalty for  shipments up to certain volume levels and a per unit royalty for any  units sold above these stated amounts. For 2005, the Engine Group expects to deliver continued growth from  further penetration of diesel engines in Europe, which will continue  to boost demand for turbochargers and Beru technologies, and the  launch of our first high-volume variable cam timing (VCT) system.  Investments in Korea and China are expected to begin to contribute  to results. This growth is expected to help offset anticipated weak- ness in North American light vehicle production. The royalty agreement costs recognized under the agreements were  $14.2 million in 2004, $23.2 million in 2003 and $13.5 million in  2002. These costs were based on units shipped and were recorded  in cost of goods sold. It is anticipated that these costs will be at  minimal levels in 2005 and 2006 as the Company’s primary custom- ers have converted most of their requirements to the next generation  VTG turbocharger. Corporate  is the difference between calculated total Company EBIT  and the total from the segments and represents corporate headquar- ters expenses and expenses not directly attributable to the individual  segments and includes equity in affiliate earnings. This net expense  was $50.3 million in 2004, $48.0 million in 2003, and $44.3 million in  2002. The main reasons for the increase from 2003 to 2004 was an  increase in our environmental spending related to the Crystal Springs,  Mississippi site and the $3.7 million write down of a note relating to the  sale of Kuhlman Electric Corporation, which were mostly offset by stron- ger equity earnings from NSK-Warner. The increase from 2002 to 2003  was due to higher pension and post retirement health care costs for  discontinued operations, which are recorded at the corporate level. Selling, general and administrative  expenses (SG&A) as a per- centage of net sales decreased to 9.6% from 10.3% in 2003 and  11.1% in 2002. While SG&A spending in dollars increased slightly, we  were able to slow that growth to a level below the growth in sales  through continued focus on cost controls, and leveraging the existing  infrastructure to support the increased sales. Research and development (R&D) is a major component of the  Company’s SG&A expenses. R&D spending was $123.1 million, or  3.5% of sales in 2004, compared to $118.2 million, or 3.9% of sales  in 2003, and $109.1 million, or 4.0% of sales in 2002. We continue  to increase our spending in R&D, although the growth rate has been  somewhat lower than our sales growth rate. We also continue to invest  in a number of cross-business R&D programs, as well as a number of  other key programs, all of which are necessary for short- and long- term growth. Our long-term target for R&D spending is approximately  4% of sales. We intend to maintain our commitment to R&D spending  while continuing to focus on controlling other SG&A costs. The following table details our results of operations as a percentage  of sales:  Other, net  decreased to $(3.0) million of loss in 2004, from $0.1 mil- lion of income in 2003 and $0.9 million of income in 2002. The major  item was losses from capital asset disposals of $3.5 million in 2004. Equity in affiliates earnings, net of tax  increased by $9.1 million  from 2003, and by $0.6 million between 2003 and 2002. This line  item is primarily driven by the results of our 50% owned Japanese  joint venture, NSK-Warner. For more discussion of NSK-Warner, see  Note 5 of the Consolidated Financial Statements.  Other Factors Affecting Results of Operations Year Ended December 31,  2004 2003 2002 Net sales 100.0% 100.0% 100.0% Cost of sales  81.5 80.9 79.7 Gross profit  18.5 19.1 20.3 Selling, general and   administrative  expenses  9.6 10.3 11.1 Other, net  0.1  —  —  Operating income  8.8 8.8 9.2 Equity in affiliate earnings, net of tax  -0.8 - 0.7 - 0.7 Interest expense and finance charges  0.8 1.1 1.4 Earnings before income taxes  8.8 8.4 8.5 Provision for income taxes  2.3 2.4 2.8 Minority interest, net of tax  0.3 0.3 0.2 Net earnings before cumulative effect  of  accounting  change  6.2% 5.7% 5.5% NET SALES millions of dollars  Year ended December 31,  2004  2003   2002  Drivetrain  $1,358.6 $1,245.6 $1,122.1 Engine  2,217.0 1,869.7 1,648.2 Inter-segment eliminations  (50.3) (46.1) (39.2) Net sales  $3,525.3 $3,069.2 $2,731.1 millions of dollars  Year ended December 31,   2004  2003   2002  Drivetrain  $106.9 $ 98.4  $ 99.9 Engine  281.7 239.6 215.9 Segment earnings before interest  and taxes 388.6 338.0 315.8 Corporate  (50.3) (48.0) (44.3) Consolidated earnings before interest and taxes  $338.3 $290.0 $271.5 Interest expense and finance  charges  29.7 33.3 37.7 Earnings before income taxes  $308.6 $256.7 $233.8 WORLDWIDE LIGHT VEHICLE  YEAR OVER YEAR CHANGE IN PRODUCTION* 2004 2003 North America  (0.7)% (3.0)% Europe 5.0% 1.4% Japan and Korea  3.9% (0.7)% Total World-wide  5.2% (1.6)% *Data provided by CSM Worldwide. BorgWarner Year Over Year Net Sales Change  14.9% 12.4% Results By Operating Segment RESULTS OF OPERATIONS Net Sales The following tables present net sales and earnings before interest and  income taxes (EBIT) by segment for the years 2004, 2003 and 2002. The table below summarizes the overall worldwide global light vehicle  production percentage changes for 2004 and 2003: EARNINGS BEFORE INTEREST AND TAXES (EBIT) Our net sales increase in 2004 and 2003 was strong compared to the  estimated worldwide market production increase of approximately  5.2% in 2004 and decrease of (1.6)% in 2003. The Company’s net  sales increased 14.9% from 2003 and increased 12.4% from 2002 to  2003. The increase in 2004 was driven by both of our operating seg- ments from higher demand for turbochargers, especially in Europe;  new DualTronic™ transmissions; all-wheel drive systems; and timing  chain systems in Asia and Europe. The effect of changing currency  rates also had a positive impact on net sales and net earnings in  2004. The effect of non-U.S. currencies, primarily the Euro, U.K.  Pound, Japanese Yen and Korean Won, added $114.0 million to net  sales in 2004 and $161.9 million in 2003. The year over year increase  in net sales excluding the favorable impact of currency was 11.1% in  2004 and 6.5% in 2003. The  Drivetrain  segment net sales increased 9.1% from 2003 to  2004; EBIT increased 8.6% for the same period. The sales increase  was the result of strong global demand for transmission compo- nents and all-wheel drive systems. The Company’s new DualTronic™  transmission product continues to ramp-up volume in Europe. The  increase in EBIT was due to increased volume and continued focus on  cost reductions in our operations. These positive trends were offset  by commodity price increases of approximately $20 million, which is  primarily steel, and start up costs. Consolidated net sales included sales to Ford Motor Company of  approximately 21%, 23%, and 26%; to DaimlerChrysler of approxi- mately 14%, 17%, and 20%; and to General Motors Corporation of  approximately 10%, 12%, and 12% for the years ended December  31, 2004, 2003 and 2002, respectively. Sales to Volkswagen were  approximately 10% in 2004. Both of our operating segments had  significant sales to all four of the customers listed above. Such sales  consisted of a variety of products to a variety of customer locations  and regions. No other single customer accounted for more than 10%  of consolidated sales in any year of the periods presented. The Drivetrain segment net sales increased 11.0% from 2002 to 2003,  but EBIT declined 1.5% for the same period. The sales gains were  due to all-wheel drive transfer case programs with General Motors,  increased sales of the Company’s Interactive Torque Management ™  all-wheel drive systems to Honda and Hyundai, and steady demand  for transmission components and systems, especially with increased  automatic transmission adoption in Europe. These sales gains were  offset by declines in North American automotive production. The  decrease in EBIT was due to start-up costs for the Company’s new  DualTronic™ transmission product, including the opening of a new  assembly facility in Europe. Profitability also suffered from a less  favorable product mix and an increase in pension and retiree health  care costs over the previous year. Over the past several years as our major customers have continued  to consolidate, we have increased our sales to several other global  OEMs, bringing us more in line with our customers’ share of the  global vehicle market. As a result, sales to Ford, DaimlerChrysler and  General Motors have become a smaller percentage of total sales.  In 2005, growth in the Drivetrain segment is expected to be flat as  demand for traditional light-trucks will be about the same as in 2004.  Sport-utility vehicles are expected to decline, while sales of front- wheel-drive based all-wheel-drive systems are expected to increase.  Transmission products will benefit from increased penetration of auto- matic transmissions in Europe and Asia, and the continued ramp-up of  DualTronic™ transmission modules in Europe.  Our overall outlook for 2005 is positive. Sales are expected to grow  in excess of a projected flat to slightly positive global production rate  and we expect to benefit from the continuation of several trends:  change in Europe to diesel engines, which utilize turbochargers and  certain Beru products; shift in Europe to automatic transmissions;  and the switch from timing belts to timing chains in Asia and Europe.  Each of these trends is positive for the Company. Assuming no major  changes to the above assumptions, the Company expects continued  long-term sales and net earnings growth.