Overview

General

Lufkin Industries is a global supplier of oil field and power transmission products. Through its Oil Field segment, the Company manufactures and services artificial reciprocating rod lift equipment and related products, which are used to extract crude oil and other fluids from wells. Through its Power Transmission segment, the Company manufactures and services high-speed and low-speed increasing and reducing gearboxes for industrial applications. While these markets are price-competitive, technological and quality differences can provide product differentiation.

The Company's strategy is to differentiate its products through additional value-added capabilities. Examples of these capabilities are high-quality engineering, customized designs, rapid manufacturing response to demand through plant capacity, inventory and vertical integration, superior quality and customer service, and an international network of service locations. In addition, the Company's strategy is to maintain a low debt-to-equity ratio in order to quickly take advantage of growth opportunities and pay dividends even during unfavorable business cycles.

In support of the above strategy, the Company has been making capital investments in Oil Field to increase manufacturing capacity and capabilities in its three main manufacturing facilities in Lufkin, Texas, Canada and Argentina. These investments should reduce production lead times, improve quality and reduce manufacturing costs. Investments also continue to be made to expand the Company's presence in automation products and international service. In Power Transmission, the Company continues to expand its gear repair network by opening and expanding facilities in various locations in the U.S. and Canada. The Company is making targeted capital investments in the U.S. and France to expand capacity and reduce manufacturing lead times as well as certain capital investments targeting cost reductions.

Trends/Outlook

Oil Field
Demand for pumping unit equipment primarily depends on the level of new onshore oil well and workover drilling activity as well as the depth and fluid conditions of that drilling. Drilling activity is driven by the available cash flow of the Company's customers as well as their long-term perceptions of the level and stability of the price of oil. The higher energy prices experienced since 2004 have increased the demand for pumping units and related service and products from higher drilling activity, activation of idle wells and the upgrading of existing wells. During 2007, demand in the North American market was negatively affected by the impact of lower natural gas prices on coal-bed methane and other unconventional gas production that use rod pumps to de-water wells, drilling program delays from M&A activity, cost control efforts deferring or reducing capital spending programs and the competitive pressure from lower-priced pumping units in areas traditionally served by the used unit market. Traditionally, as pumping unit demand increases and availability of used equipment diminishes, demand for new equipment increases. In 2007, lower-priced imported pumping units entered the North American market in place of used equipment and reduced the incremental demand for the Company's new pumping units. During the first nine months of 2008, demand levels in North America increased over the levels experienced in the latter half of 2007 as higher energy prices drove increased drilling and workover activity. Additionally, the demand for pumping units, oilfield services and automation equipment continued to increase in international markets.

In the fourth quarter of 2008, energy prices dramatically declined due to reductions in global demand. Planned new drilling and workover activity has also reduced significantly as capital budgets have been cut. E&P companies have reduced drilling in higher-cost fields that are not economically viable at lower energy prices and have lowered overall capital budgets in order to remain cash-flow positive and avoid the more-expensive credit markets. These declines have been more pronounced in the U.S., but are expected to be reflected in international markets in future periods. New pumping unit booking levels declined in the fourth quarter of 2008 from lower demand, order cancellations for units scheduled to ship in 2009 and price reductions for units scheduled to ship in 2009. These price reductions have primarily been in response to the decline in raw material costs in the fourth quarter of 2008 for steel and iron castings. Gross margin levels may be negatively impacted from these reductions and from reduced plant utilizations.

While the market is suffering a cyclical decline, the Company continues to believe that there are long-term positive growth trends for artificial lift equipment, and as existing fields mature, the market will require an increased use of pumping units for artificial lift, especially in the South American, Russian and Middle Eastern markets.

Power Transmission
Power Transmission services many diverse markets, with high-speed gearing for markets such as petrochemicals, refineries, offshore production and transmission of oil and slow-speed gearing for the gas, rubber, sugar, paper, steel, plastics, mining, cement and marine propulsion, each of which has its own unique set of drivers. Generally, if general global industrial capacity utilizations are not high, spending on new equipment lags. Also impacting demand are government regulations involving safety and environmental issues that can require capital spending. Recent market demand increases have come from energy-related markets such as refining, petrochemical, drilling, coal, marine and power generation in response to higher global energy prices. While recent declines in energy prices have not impacted demand, sustained lower energy prices could reduce demand for power transmission products and services in future periods. Because power transmission products are generally components in large-scale projects that tend to have longer lead-times, bookings are not as volatile. Due to lower energy prices and access to capital markets, customers may reduce future large-scale energy-related projects. However, governments are increasing funding for infrastructure and alternative energy projects for economic stimulus purposes, which may create opportunities for power transmission products.

Discontinued Operations
During the second quarter of 2008, the Trailer segment was classified as a discontinued operation. In January 2008, the Company announced the decision to suspend its participation in the commercial trailer markets and to develop a plan to run-out existing inventories, fulfill contractual obligations and close all trailer facilities in 2008. During the second quarter of 2008, this plan was completed, with the majority of the remaining inventory and manufacturing equipment sold and all facilities closed.

Trailer generated income of $0.2 million, $2.4 million and $1.7 million, net of tax, during 2008, 2007 and 2006, respectively.

Other
During the fourth quarter of 2008, the Company booked a contingent liability provision of $6.0 million (pre-tax) for its ongoing class-action lawsuit. See Item 3 for additional information.

Summary of Results

The Company generally monitors its performance through analysis of sales, gross margin (gross profit as a percentage of sales) and net earnings, as well as debt/equity levels, short-term debt levels, and cash balances. Prior period amounts have been reclassified to reflect the impact of discontinued operations.

Overall, sales for 2008 increased to $741.2 million from $555.8 million for 2007, or 33.4%, and $401.2 million for 2006. This increase was primarily driven by increased sales of Oil Field products and services in the U.S. market but also from continued growth in Power Transmission sales.

Gross margin for 2008 decreased to 28.9% from 29.2% for 2007, primarily due to non-cash additions to LIFO inventory reserves related to the inflationary impact of higher raw material prices for steel and castings. However, gross margin levels increased over the 2006 level of 28.7% due to the favorable mix towards new pumping unit sales. Additional segment data on gross margin is provided later in this section.

Higher selling, general and administrative expenses also negatively impacted net earnings, with these expenses increasing to $72.0 million during 2008 from $57.6 million during 2007 and $50.8 million during 2006. This increase was primarily related to higher divisional spending to support higher sales volume, higher third-party commissions and increases in bad debt provisions. However, as a percentage of sales, selling, general and administrative expenses decreased to 9.7% during 2008 compared to 10.4% during 2007 and were flat with 2006.

The Company reported net earnings from continuing operations of $88.0 million, or $5.91 per share (diluted), for 2008, compared to net earnings from continuing operations of $71.8 million, or $4.76 per share (diluted), for 2007, and reported net earnings from continuing operations of $71.3 million, or $4.72 per share (diluted), for 2006.

Debt/equity (long-term debt net of current portion as a percentage of total equity) levels were 0.0% as of December 31, 2008 and December 31, 2007. Cash balances at December 31, 2008, were $107.8 million, up from $95.7 million at December 31, 2007.

Year Ended December 31, 2008 Compared to Year Ended December 31, 2007:

The following table summarizes the Company's sales and gross profit by operating
segment (in thousands of dollars):

                                                      Increase/       % Increase/
Year Ended December 31     2008          2007        (Decrease)       (Decrease)

Sales
Oil Field                $ 551,814     $ 397,354     $   154,460              38.9
Power Transmission         189,380       158,452          30,928              19.5
Total                    $ 741,194     $ 555,806     $   185,388              33.4



Gross Profit
Oil Field            $ 153,673     $ 109,091     $ 44,582        40.9
Power Transmission      60,286        52,476        7,810        14.9
Adjustment*                115           701         (586 )     (83.6 )
Total                $ 214,074     $ 162,268     $ 51,806        31.9

Due to the discontinuation of the Trailer segment, certain items previously allocated to that segment in cost of sales have been reclassified to continuing operations. The adjustment is related to pension and postretirement charges associated with Trailer personnel that will continue to be a liability in future years.

Oil Field

Oil Field sales increased to $551.8 million, or 38.9%, for the year ended December 31, 2008, from $397.4 million for the year ended December 31, 2007. New unit sales of $342.1 million during 2008 were up $113.9 million, or 49.9%, compared to $228.2 million during 2007, primarily from higher U.S. demand. Service sales of $103.0 million during 2008 were up $20.8 million, or 25.3%, compared to $82.2 million during 2007, from growth in the U.S. market. Automation sales of $82.4 million during 2008 were up $25.5 million, or 44.8%, compared to $56.9 million during 2007, from growth in U.S. sales. Commercial casting sales of $24.4 million during 2008 were down $5.7 million, or 19.0%, compared to $30.1 million during 2007, from lower sales to the machine tool market. Oil Field's backlog also increased to $188.1 million as of December 31, 2008, from $76.9 million at December 31, 2007. This increase was driven by increased bookings for new units for the U.S. and Latin American markets as higher energy prices drove increased drilling and workover activity. Also, certain U.S. customers placed orders for new units to be shipped through the first half of 2009 versus their normal buying practice of ordering units as needed.

Gross margin (gross profit as a percentage of sales) for the Oil Field segment increased to 27.8%, or 0.3 percentage points, for year ended December 31, 2008, compared to 27.5% for the year ended December 31, 2007. This gross margin increase was related to price increases instituted to offset material price increases and the favorable mix effect of increased new unit sales, partially offset by increased non-cash additions to LIFO inventory reserves of $4.1 million, or 0.7 percentage points of gross margin, related to the inflationary impact of higher raw material prices for steel and castings.

Direct selling, general and administrative expenses for Oil Field increased to $22.6 million, or 31.8%, for the year ended December 31, 2008, from $17.1 million for the year ended December 31, 2007. This increase is due to higher employee-related expenses in support of increased sales volumes, third-party commissions and bad debt provisions. In the fourth quarter of 2008, a provision of $1.2 million was made for the probable bankruptcy of a Middle East customer. However, direct selling, general and administrative expenses as a percentage of sales decreased to 4.1% for the year ended December 31, 2008, from 4.3% for the year ended December 31, 2007.

Power Transmission

Sales for the Company's Power Transmission segment increased to $189.4 million, or 19.5%, for the year ended December 31, 2008, compared to $158.5 million for the year ended December 31, 2007. New unit sales of $144.9 million during 2008 were up $24.7 million, or 20.5%, compared to $120.2 million during 2007, from increased sales of high-speed units for the oil and gas markets and increased sales of marine units for the coastal, river and inland-waterway transportation markets. Repair and service sales of $44.5 million during 2008 were up $6.3 million, or 16.4%, compared to $38.2 million during 2007. Power Transmission backlog at December 31, 2008, increased to $129.3 million from $122.2 million at December 31, 2007, primarily from increased bookings of new units for the energy-related and marine markets.

Gross margin for the Power Transmission segment decreased to 31.8%, or 1.3 percentage points, for the year ended December 31, 2008, compared to 33.1% for the year ended December 31, 2007. This gross margin decrease was primarily from increased non-cash additions to LIFO inventory reserves of $1.7 million, or 0.9 percentage points of gross margin, related to the inflationary impact of higher raw material prices for steel and castings and from the unfavorable mix effect of increased marine unit sales.

Direct selling, general and administrative expenses for Power Transmission increased to $23.5 million, or 32.1%, for the year ended December 31, 2008, from $17.8 million for the year ended December 31, 2007. This increase was due to higher employee-related expenses in support of increased sales volumes, third-party commissions in certain international markets and bad debt provisions. In the fourth quarter of 2008, a provision of $1.2 million was made for the bankruptcy of a U.S. petrochemical customer. Direct selling, general and administrative expenses as a percentage of sales increased to 12.4% for the year ended December 31, 2008, from 11.2% for the year ended December 31, 2007.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on historical third-party revenues, were $25.9 million for the year ended December 31, 2008, an increase of $3.2 million or 12.5%, from $22.7 million for the year ended December 31, 2007, primarily from higher personnel-related expenses in support of sales volume growth and increased professional service fees.

Interest income, interest expense and other income and expense for the year ended December 31, 2008, decreased to $0.3 million of income compared to income of $4.8 million for the year ended December 31, 2007, primarily due to lower interest rates on invested cash balances and the unfavorable currency impact of the weakening Canadian dollar during 2008 compared to 2007.

Pension income, which is reported as a reduction of cost of sales, decreased to $1.3 million for the year ended December 31, 2008, or 60%, compared to $3.3 million for the year ended December 31, 2007. This decrease was primarily due to lower expected returns on asset balances. In 2009, pension expense of approximately $8.0 million is expected due to the significant declines in the market value of the qualified pension plan assets during 2008.

The net tax rate for the year ended December 31, 2008, was 35.5% compared to 34.4% for the year ended December 31, 2007. The net tax rate in 2007 benefitted from a reduction in tax reserves on items falling out of statute. Also, the 2008 net tax rate was unfavorably impacted by higher state taxes due to the mix of sales shifting towards higher-tax jurisdictions. The 2009 tax rate is expected to continue at approximately 35.5%.

Due to the discontinuation of the Trailer segment, certain items previously allocated to that segment have been reclassified to continuing operations. One adjustment is related to pension and postretirement charges associated with Trailer personnel that will continue to be a liability in future years. The other adjustment is for corporate allocations previously charged to Trailer, as these expenses will continue in the future.

Year Ended December 31, 2007 Compared to Year Ended December 31, 2006:

The following table summarizes the Company's sales and gross profit by operating
segment (in thousands of dollars):

                                                      Increase/       % Increase/
Year Ended December 31     2007          2006        (Decrease)       (Decrease)

Sales
Oil Field                $ 397,354     $ 401,200     $    (3,846 )            (1.0 )
Power Transmission         158,452       124,922          33,530              26.8
Total                    $ 555,806     $ 526,122     $    29,684               5.6



Gross Profit
Oil Field            $ 109,091     $ 109,414     $   (323 )     (0.3 )
Power Transmission      52,476        41,024       11,452       27.9
Adjustment*                701           762          (61 )     (8.0 )
Total                $ 162,268     $ 151,200     $ 11,068        7.3

Due to the discontinuation of the Trailer segment, certain items previously allocated to that segment in cost of sales have been reclassified to continuing operations. The adjustment is related to pension and postretirement charges associated with Trailer personnel that will continue to be a liability in future years.

Oil Field

Oil Field sales decreased slightly to $397.4 million, or 1.0%, for the year ended December 31, 2007, from $401.2 million for the year ended December 31, 2006. Increased sales of oil field services, automation equipment and new pumping units in the Middle East and Argentina markets was offset by lower sales of new pumping units in the North American market. Oil Field's backlog increased to $76.9 million as of December 31, 2007, from $67.1 million at December 31, 2006. This increase is related to increased orders for the Argentina and Middle East markets, partially offset by weaker demand for new pumping units in the North American market.

Gross margin (gross profit as a percentage of sales) for the Oil Field segment increased slightly to 27.5%, or 0.2 percentage points, for the year ended December 31, 2007, compared to 27.3% for the year ended December 31, 2006.

Direct selling, general and administrative expenses for Oil Field increased to $17.5 million, or 12.1%, for the year ended December 31, 2007, from $15.6 million for the year ended December 31, 2006. This increase is due to higher employee-related expenses in support of increased sales levels. Direct selling, general and administrative expenses as a percentage of sales also increased to 4.4% for the year ended December 31, 2007, from 3.9% for the year ended December 31, 2006.

Power Transmission

Sales for the Company's Power Transmission segment increased to $158.5 million, or 26.8%, for the year ended December 31, 2007, compared to $124.9 million for the year ended December 31, 2006. This growth was the result of increased sales of high-speed units to the energy-related markets, such as power generation and oil and gas drilling, production and refining from both the U.S. and France manufacturing facilities and low-speed marine units for the coastal, river and inland-waterway transportation market. Power Transmission backlog at December 31, 2007, increased to $122.2 million from $95.6 million at December 31, 2006, primarily from sales of new units for the marine and oil-drilling markets.

Gross margin for the Power Transmission segment increased to 33.1% for the year ended December 31, 2007, compared to 32.8% for the year ended December 31, 2006, from increased plant efficiencies and fixed cost coverage from higher production volumes and the benefit of greater sales of high-speed units.

Direct selling, general and administrative expenses for Power Transmission increased to $18.3 million, or 17.4%, for the year ended December 31, 2007, from $15.6 million for the year ended December 31, 2006. This increase is due to higher employee-related expenses in support of increased sales volumes. Direct selling, general and administrative expenses as a percentage of sales, however, decreased to 11.6% for the year ended December 31, 2007, from 12.5% for the year ended December 31, 2006.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on historical third-party revenues, increased to $21.6 million, or 11.8%, for the year ended December 31, 2007, from $19.3 million for the year ended December 31, 2006, primarily from the higher employee-related expenses and stock option expenses.

Net interest income, interest expense and other income and expense for the year ended December 31, 2007, totaled $4.8 million of income compared to income of $1.5 million for the year ended December 31, 2006, primarily due to an increase in interest income from higher cash balances and the favorable impact of the stronger Canadian currency on U.S. dollar-denominated liabilities.

Pension income, which is reported as a reduction of cost of sales, increased to $3.3 million, or 12%, for the year ended December 31, 2007, or 12%, compared to $2.9 million for the year ended December 31, 2006, primarily from expected asset returns exceeding expected expense increases.

The net tax rate for the year ended December 31, 2007, was 34.4% compared to 30.0% for the year ended December 31, 2006. The lower net tax rate in 2006 was the result of several items. A tax initiative to claim research and experimentation tax credits for the 2002 through 2005 tax years and the recent legislation passed to allow a research and experimentation tax credit for the 2006 tax year produced a significant benefit to the tax rate. A lower effective state tax rate, and the related benefit to deferred tax balances, combined with the favorable impact on state deferred tax balances due to the new Texas margin tax also produced a benefit to the net tax rate. Other items such as lower international tax rates and revisions to prior period estimates produced additional benefits to the net tax rate.

Due to the discontinuation of the Trailer segment, certain items previously allocated to that segment have been reclassified to continuing operations. One adjustment is related to pension and postretirement charges associated with Trailer personnel that will continue to be a liability in future years. The other adjustment is for corporate allocations previously charged to Trailer as these expenses will continue in the future.

Liquidity and Capital Resources

The Company has historically relied on cash flows from operations and third-party borrowing to finance its operations, including acquisitions, dividend payments and stock repurchases. The Company believes that its cash flows from operations and its available borrowing capacity under its credit agreements will be sufficient to fund its operations, including planned capital expenditures, dividend payments and stock repurchases, through December 31, 2009, and the foreseeable future.

The Company's cash balance totaled $107.8 million at December 31, 2008, compared to $95.7 million at December 31, 2007. For the year ended December 31, 2008, net cash provided by operating activities from continuing operations was $48.9 million, net cash used in investing activities by continuing operations totaled $28.8 million and net cash used by financing activities amounted to $7.0 million. Significant components of cash provided by operating activities from continuing operations included net earnings, adjusted for non-cash expenses, of $112.3 million, offset by an increase in working capital of $63.4 million. This working capital increase was primarily due to increased FIFO inventory balances of $46.2 million from higher production activity in Oil Field and Power Transmission and strategic steel purchases, higher receivables balances of $52.6 million due to sales volume increases, partially offset by increased accounts payable of $24.2 million. Net cash used in investing activities was primarily from net capital expenditures totaling $29.6 million for the expansion of manufacturing and service capacity and efficiency improvements in the Oil Field and Power Transmission segments. Capital expenditures for 2009 are projected to be approximately $30.0 million, primarily for the expansion of manufacturing and service capacity and equipment replacement for efficiency improvements in the Oil Field and Power Transmission segments and will be funded by operating cash flows. Additional strategic capital expenditures of $30.0 million may be authorized depending on market outlooks and available operating cash flows. Significant components of net cash used by financing activities included dividend payments of $14.8 million, or $1.00 per share and treasury stock purchases of $4.6 million, offset by the impact of stock option exercises, including the excess tax benefit from actual gains on stock option exercises, of $12.4 million.

The Company has a three year credit facility with a domestic bank (the "Bank Facility") consisting of an unsecured revolving line of credit that provides up to $40.0 million of aggregate borrowing. This Bank Facility expires on December 31, 2010. Borrowings under the Bank Facility bear interest, at the Company's option, at either the greater of (i) the prime rate, (ii) the base CD rate plus an applicable margin or (iii) the Federal Funds Effective Rate plus an applicable margin or the London Interbank Offered Rate plus an applicable margin, depending on certain ratios as defined in the Bank Facility. As of December 31, 2008, no debt was outstanding under the Bank Facility and the Company was in compliance with all financial covenants under the terms of the Bank Facility. Deducting outstanding letters of credit of $7.9 million, $32.1 million of borrowing capacity was available at December 31, 2008.

During 2008, the Company repurchased shares pursuant to a plan approved by the Board of Directors in the third quarter of 2007, under which the Company was authorized to spend up to an aggregate of $30.0 million for repurchases of its common stock. Repurchased shares are added to treasury stock and are available for general corporate purposes including the funding of the Company's stock option plans. During 2008, 71,890 shares were repurchased under the above plans at an aggregate price of $4.6 million, or an average price of $64.30 per share. As of December 31, 2008, 534,021 shares had been repurchased under the 2007 plan at an aggregate price of $30.0 million, or $56.17 per share. During the fourth quarter of 2008, 51,890 shares were repurchased under the 2007 plan at an aggregate price of $3.5 million, or $67.54 per share. As of December 31, 2008, the Company held 931,168 shares of treasury stock at an aggregate cost of approximately $34.9 million. At December 31, 2008, no repurchase authorizations remained under the 2007 plan.

The following table summarizes the Company's expected cash outflows from financial contracts and commitments as of December 31, 2008. Information on recurring purchases of materials for use in manufacturing and service operations has not been included. These amounts are not long-term in nature (less than three months) and are generally consistent from year to year.

. . .