OVERVIEW

Sun Hydraulics Corporation is a leading designer and manufacturer of high-performance screw-in hydraulic cartridge valves and manifolds, which control force, speed and motion as integral components in fluid power systems. The Company sells its products globally through wholly owned subsidiaries and independent distributors. Sales outside the United States for the year ended December 27, 2008, were approximately 58% of total net sales.

Approximately two-thirds of product sales are used by the mobile market, which is characterized by applications where the equipment is not fixed in place, the operating environment is often unpredictable, and duty cycles are generally moderate to low. Some examples of the mobile market include equipment used in off-road construction, agriculture, fire and rescue, utilities, oil fields, and mining.

The remaining one-third of sales are used by industrial markets, which are characterized by equipment that is fixed in place, typically in a controlled environment, and which operates at higher pressures and duty cycles. Power units, automation machinery, metal cutting machine tools and plastics machinery are some examples of industrial equipment. The Company sells to both markets with a single product line.

Industry conditions

Demand for the Company's products is dependent on demand for the capital goods into which the products are incorporated. The capital goods industries in general, and the fluid power industry specifically, are subject to economic cycles. According to the National Fluid Power Association (the fluid power industry's trade association in the United States), the United States index of shipments of hydraulic products increased 8% and 1% in 2008 and 2007, respectively. The index of shipments of hydraulic products decreased 31% for the three month period ending March 2009, compared to the same period of the prior year.

The Company's order trend has historically tracked closely to the United States Purchasing Managers Index (PMI). The index decreased to 36.3 in March 2009 compared to 49.0 in March 2008. In April 2009, the index increased to 40.1. When PMI is over 50, it indicates economic expansion; when it is below 50, it indicates contraction in the economy. PMI reached a low point in December 2008, at 32.9. It has since increased in four consecutive months, up nearly 22% in April 2009 compared to December 2008.

Results for the first quarter

(Dollars in millions except net income per share)

                                      March 28,     March 29,
                                        2009          2008       Decrease
              Three Months Ended
             Net Sales               $      25.2   $      49.0        -49 %
             Net Income              $       0.6   $       7.7        -92 %
             Net Income per share:
             Basic                   $      0.03   $      0.46        -93 %
             Diluted                 $      0.03   $      0.46        -93 %

First quarter sales were in line with what management expected, however earnings were a little better than anticipated. Cash flow remains positive, allowing the Company to continue taking actions that will improve its place in the market when demand rallies.

This spring, the Company released new automated design software that has been in development for four years. The software enhances the ease by which the Company's distribution partners can configure and specify integrated packages. This new service automates the design effort and with no human intervention designs the package and prepares all necessary documentation. Management believes this web-based software will stimulate increased cartridge sales around the world.

Management believes that we are getting close to, and may have, reached the bottom of this difficult economic cycle. There are some positive signals out there, most notably the Purchasing Manager's Index, which has now reported four consecutive months of upward movement. While the magnitude is small, upward is the right direction and this index has proven to be a reliable directional indicator of the Company's business. The Company's strong financial foundation enables it to maintain its readiness, continue paying its dividend and prepare for the next expansion. This is a result of being diligent in managing its business throughout the business cycle.

Outlook

The Company's 2009 second quarter sales are expected to be approximately $21 million, a 60% decrease in revenue compared to last year, and earnings are expected to be slightly below breakeven.

The Company has taken steps to mitigate the effects of declining demand including curtailing non-essential spending. The Company's priority remains to invest in capability, capacity, quality, productivity, product development and expanding the Sun brand globally. Any actions to balance production with demand will not compromise the Company's long-term objectives at the expense of quarterly results. Based on previous business cycles, the Company's market share grows and earnings benefit by maintaining a steady course at the bottom of the cycle.

COMPARISON OF THE THREE MONTHS ENDED MARCH 28, 2009 AND MARCH 29, 2008

Net Sales

Net sales were $25.2 million, a decrease of $23.8 million, or 48.6%, compared to $49.0 million in 2008. Net sales decreased 42.6% excluding the effect of exchange rates. The decrease in net sales was primarily driven by decreased demand in our end markets, which primarily include capital goods equipment. Price increases in October 2008 accounted for approximately 2% of sales. New product sales (defined as products introduced within the last five years) generally make up 15% of total sales.

North American sales decreased 43.0% or $9.1 million, to $12.0 million, Asian sales decreased 64.6% or $6.4 million, to $3.5 million, and European sales decreased 46.2% or $7.8 million, to $9.1 million.

The U.S. reporting segment had sales of $15.6 million in the first quarter of 2009, down $12.7 million or 44.8%, compared to sales of $28.3 million during the first quarter last year. The decrease was driven by demand in our end markets and the general downturn in the global economy. International sales out of the U.S. were $4.7 million during the first quarter of 2009, down 50.5% or $4.8 million, compared to $9.5 million during the first quarter last year. Significant decreases in sales were noted in all geographic regions.

The Korean reporting segment had sales of $2.0 million during the first quarter of 2009, down $4.4 million or 69.1%, compared to sales of $6.4 million during the first quarter last year. Currency effect reduced 2009 first quarter sales by approximately $0.9 million. The remaining decrease was related to a slowdown in sales to four major Korean customers that are in the construction equipment industry.

The German reporting segment had sales of $4.2 million during the first quarter of 2009, down $3.8 million or 47.7%, compared to sales of $8.0 million during the first quarter last year. Currency effect reduced 2009 first quarter sales by approximately $0.7 million. The remaining decrease is primarily related to demand within Germany however, sales were down in all geographic markets.

The U.K. reporting segment had sales of $3.5 million during the first quarter of 2009, down $2.9 million or 45.7%, compared to sales of $6.4 million during the first quarter last year. Currency effect reduced 2009 first quarter sales by approximately $0.7 million. The largest reduction of sales was to customers within the U.K. however, sales were down in all geographic markets.

Gross Profit

Gross profit decreased $11.5 million or 67.4% to $ 5.6 million in the first quarter of 2009, compared to $17.1 million in the first quarter last year. Gross profit as a percentage of net sales decreased to 22.1% in the first quarter of 2009, compared to 34.9% in the first quarter last year. The Company experienced a sharp decline in sales during the fourth quarter of 2008, which resulted in gross profit margins of 24.9%. Sales continued to decline in the first quarter of 2009, resulting in further reductions in the gross profit margin.

The 2009 gross profit decreases were primarily related to lower sales volume, which contributed $8.3 million of the decrease. The remaining decreases in gross profit were attributed to productivity declines of approximately $1.1 million, and increases in overhead expenses as a percentage of sales of approximately $2.6 million, both of which occurred primarily in the U.S. The decrease in gross profit was partially offset by lower material costs of approximately $0.5 million, primarily in the U.S. and U.K.

The Company believes in maintaining its workforce and continuing to invest in people and processes throughout its business cycle. The Company's history has proven that this approach allows it to reap the benefits of a trained and agile workforce when the market turns up. The Company has and continues to make efforts to reduce its fixed overhead expenses. Significant reductions in overhead expenses resulted from reduced retirement benefits of $1.1 million, primarily from the shared distribution that was included in the prior year results, and reduced overtime premiums of $0.4 million. However, in periods of sharp declining sales, the Company cannot reduce costs at the same pace.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses decreased 19.8%, or $1.2 million, to $4.8 million compared to the same quarter last year. The change is primarily a result of decreases in compensation of $0.3 million, fringe benefit costs of $0.3 million, and travel of $0.1 million. The decrease in fringe benefits is primarily related to retirement benefits associated with the shared distribution that was included in the prior year results.

Operating Income

Operating income decreased $10.3 million or 92.8% to $0.8 million in the first quarter of 2009, compared to $11.1 million in the first quarter last year, with operating margins of 3.2% and 22.7% for the first quarters of 2009 and 2008, respectively. The sharp decline in sales is the primary cause for the reduction in operating income margins. While all reporting segments were able to reduce fixed costs, as sales fall sharply, the Company cannot decrease costs at the same pace.

The U.S. reporting segment experienced an operating loss of $0.6 million in the first quarter of 2009, compared to operating income of $7.2 million during the first quarter of 2008, a decrease of $7.8 million. A sharp decline in sales volume reduced operating income $3.2 million. Decreases in operating income occurred from productivity declines as a result of keeping its workforce intact, and increased variable and fixed overhead costs as a percent of sales. Increases in operating income were partially offset by decreases in material costs. The Company continues to monitor and reduce fixed costs where it is deemed appropriate.

The Korean reporting segment contributed $0.1 million to our consolidated operating income during the first quarter of 2009 compared to $0.7 million during the first quarter last year, a decrease of $0.6 million. The reduction in sales volume was responsible for $0.5 million of the decrease in operating income.

The German reporting segment contributed $0.7 million to our consolidated operating income during the first quarter of 2009 compared to $2.4 million during the first quarter last year, a decrease of $1.7 million. Reduction in sales volume resulted in a decrease of $1.2 million to operating income. The remaining decrease was primarily related to material costs due to the strength of the U.S. Dollar against the Euro for material purchases made in U.S. Dollars.

The U.K. reporting segment contributed $0.5 million to our consolidated operating income during the first quarter of 2009 compared to $1.0 million during the first quarter last year, a decrease of $0.6 million. The reduction in sales volume was responsible for $0.5 million of the decrease in operating income.

Interest Income, Net

Net interest income was $0.1 million for the quarters ended March 28, 2009, and March 29, 2008. Total average debt for the quarter ended March 28, 2009, was $0.1 million compared to $0.7 million for the quarter ended March 29, 2008. Total average cash for the quarter ended March 28, 2009, was $33.0 million compared to $21.4 million for the quarter ended March 29, 2008. Although average cash increased, interest income remained relatively flat due to lower interest rates compared to the prior year. The Company did not have any outstanding variable debt during the period ended March 28, 2009.

Foreign Currency Transaction Gain, Net

There was minimal impact to net income from foreign currency in the quarters ended March 28, 2009, and March 29, 2008.

Miscellaneous (Income)/Expense, Net

There was net miscellaneous expense of $0.2 for the quarter ended March 28, 2009, compared to net miscellaneous income of $0.2 for the quarter ended March 29, 2008. Net miscellaneous (income)/expense is primarily made up of earnings from joint ventures. The prior year income includes proceeds from an insurance claim.

Income Taxes

The provision for income taxes for the quarter ended March 28, 2009, was 23.7% of pretax income compared to 32.9% for the quarter ended March 29, 2008. The change was primarily due to the relative levels of income and different tax rates in effect among the countries in which the Company sells its products, particularly from the tax benefit recognized in the U.S.

LIQUIDITY AND CAPITAL RESOURCES

Historically, the Company's primary source of capital has been cash generated from operations, although fluctuations in working capital requirements have from time to time been met through borrowings under revolving lines of credit. The Company's principal uses of cash have been to pay operating expenses, make capital expenditures, pay dividends to shareholders, repurchase Company common stock and service debt.

Cash from operations for the three months ended March 28, 2009, was $4.9 million, compared to $7.4 million for the three months ended March 29, 2008. The $2.5 million decrease in the Company's net cash flow from operations during the period was due primarily to the decrease in net income of $7.1 million, change in taxes payable/receivable of $3.7 million, and lower cash inflow from accumulation of accounts payable and accrued expenses compared to the prior year. Decreases in accounts receivable and inventory totaling $2.7 million compared to increases in the prior year totaling $8.3 million partially offset the reduction in operating cash flows. Cash on hand decreased $4.6 million from $35.3 million in 2008 to $30.7 million in 2009. However, this decrease was largely the result of purchases of marketable securities totaling $6.2 million. Days sales outstanding (DSO) were 40 and 46 at March 28, 2009, and March 29, 2008, respectively. Customer payments have not been an issue thus far and the Company does not anticipate collectability issues even in this difficult economic environment. Inventory turns decreased to 9.1 as of March 28, 2009, compared to 10.6 as of March 29, 2008.

Capital expenditures, consisting primarily of purchases of machinery and equipment, were $1.2 million for the three months ended March 28, 2009, compared to $2.4 million for the three months ended March 29, 2008. Capital expenditures for the year are projected to be approximately $7.0 million, and includes $1.7 million for real estate that will close in the second quarter. This parcel of land is sandwiched between one of our existing facilities and vacant land that the Company already owns. It provides the Company with excellent options if it determines that additional bricks and mortar are needed.

The Company declared a special dividend of $0.09 per share to shareholders of record as of March 15, 2009, payable on March 31, 2009. The Company also declared its normal quarterly dividend of $0.09 per share to shareholders of record as of March 31, 2009, payable on April 15, 2009. The declaration and payment of future dividends is subject to the sole discretion of the Board of Directors, and any determination as to the payment of future dividends will depend upon the Company's profitability, financial condition, capital needs, future prospects and other factors deemed pertinent by the Board of Directors.

The Company believes that cash generated from operations and its borrowing availability under its revolving Line of Credit will be sufficient to satisfy the Company's operating expenses and capital expenditures for the foreseeable future. In the event that economic conditions were to severely worsen for a protracted period of time, the Company would have several options available to ensure liquidity in addition to increased borrowing. Capital expenditures could be postponed since they primarily pertain to long-term improvements in operations. Additional operating expense reductions also could be made. Finally, the dividend to shareholders could be reduced or suspended.

Off Balance Sheet Arrangements

The Company uses the equity method of accounting to account for its investments in Sun China, WhiteOak and High Country Tek. The Company does not have a majority ownership in or exercise control over any of these entities. The Company does not believe that its investments in Sun China, WhiteOak, or High Country Tek qualify as Variable Interest Entities, within the scope of FASB Interpretation (FIN) No. 46(R), Consolidation of Variable Interest Entities (revised December 2003), an interpretation of ARB No. 51, nor are they material to the financial statements of the Company at March 28, 2009.

Seasonality

The Company generally has experienced increased sales during the second quarter of the year, largely as a result of the order patterns of our customers. As a result, the Company's second quarter net sales, income from operations and net income historically are the highest of any quarter during the year. However, due to the current economic conditions, the Company does not expect this pattern to continue for 2009.

Inflation

The impact of inflation on the Company's operating results has been moderate in recent years. While inflation has not had, and the Company does not expect that it will have, a material impact upon operating results, there is no assurance that the Company's business will not be affected by inflation in the future.

Critical Accounting Policies and Estimates

The Company currently applies judgment and estimates which may have a material effect on the eventual outcome of assets, liabilities, revenues and expenses for impairment of long-lived assets, accounts receivable, inventory, goodwill and accruals. The following explains the basis and the procedure for each account where judgment and estimates are applied.

Revenue Recognition

The Company reports revenues, net of sales incentives, when title passes and risk of loss transfers to the customer. The effect of material non-recurring events is provided for when they become known.

Impairment of Long-Lived Assets

In accordance with Statement of Financial Accounting Standards ("FAS") No. 144, Accounting for Impairment or Disposal of Long-lived Assets ("FAS 144"), long-lived assets, such as property and equipment, and purchased intangibles subject to amortization, are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of the asset is measured by comparison of its carrying amount to future net cash flows the asset is expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured as the amount by which the carrying amount of the asset exceeds its fair market value.

The Company assesses the recoverability of goodwill and intangible assets not subject to amortization under FAS No. 142, Goodwill and Other Intangible Assets ("FAS 142"). See Goodwill below.

Accounts Receivable

The Company sells to most of its customers on a recurring basis, primarily through distributors with which the Company maintains long-term relationships. As a result, bad debt experience has not been material. The allowance for doubtful accounts is determined on a specific identification basis by a review of those accounts that are significantly in arrears. There can be no assurance that a distributor or a large direct sale customer with overdue accounts receivable balances will not develop financial difficulties and default on payment. See balance sheet for allowance amounts.

Inventory

The Company offers a wide variety of standard products and as a matter of policy does not discontinue products. On an ongoing basis, component parts found to be obsolete through design or process changes are disposed of and charged to material cost. The Company reviews on-hand balances of products and component parts against specific criteria. Products and component parts without usage or that have excess quantities on hand are evaluated. An inventory reserve is then established for the full inventory carrying value of those products and component parts deemed to be obsolete or slow moving. See Note 5 for inventory reserve amounts.

Goodwill

The Company acquired its Korean operations in September 1998 using the purchase method. As a result, goodwill is reflected on the consolidated balance sheet. A valuation based on the cash flow method was performed at December 27, 2008. It was determined that the value of the goodwill was not impaired. There is no assurance that the value of the acquired company will not decrease in the future due to changing business conditions. See Note 6 for goodwill amounts.

Accruals

The Company makes estimates related to certain employee benefits and miscellaneous accruals. Estimates for employee benefit accruals are based on information received from plan administrators in conjunction with management's assessments of estimated liabilities related to workers' compensation, health care benefits and annual contributions to an employee stock ownership plan, established in 2004 as part of the Company's retirement plan. Estimates for miscellaneous accruals are based on management's assessment of estimated liabilities for costs incurred.

FORWARD-LOOKING INFORMATION

Certain oral statements made by management from time to time and certain statements contained herein that are not historical facts are "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934 and, because such statements involve risks and uncertainties, actual results may differ materially from those expressed or implied by such forward-looking statements. Forward-looking statements, including those in Management's Discussion and Analysis of Financial Condition and Results of Operations, are statements regarding the intent, belief or current expectations, estimates or projections of the Company, its Directors or its Officers about the Company and the industry in which it operates, and assumptions made by management, and include among other items, (i) the Company's strategies regarding growth, including its intention to develop new products; (ii) the Company's financing plans; (iii) trends affecting the Company's financial condition or results of operations; (iv) the Company's ability to continue to control costs and to meet its liquidity and other financing needs; (v) the declaration and payment of dividends; and (vi) the Company's ability to respond to changes in customer demand domestically and internationally, including as a result of standardization. Although the Company believes that its expectations are based on reasonable assumptions, it can give no assurance that the anticipated results will occur.

Important factors that could cause the actual results to differ materially from those in the forward-looking statements include, among other items, (i) the economic cyclicality of the capital goods industry in general and the hydraulic valve and manifold industry in particular, which directly affect customer orders, lead times and sales volume; (ii) conditions in the capital markets, including the interest rate environment and the availability of capital;
(iii) changes in the competitive marketplace that could affect the Company's revenue and/or cost bases, such as increased competition, lack of qualified engineering, marketing, management or other personnel, and increased labor and raw materials costs; (iv) changes in technology or customer requirements, such as standardization of the cavity into which screw-in cartridge valves must fit, which could render the Company's products or technologies noncompetitive or obsolete; (v) new product introductions, product sales mix and the geographic mix of sales nationally and internationally; and (vi) changes relating to the Company's international sales, including changes in regulatory requirements or tariffs, trade or currency restrictions, fluctuations in exchange rates, and tax and collection issues. Further information relating to factors that could cause actual results to differ from those anticipated is included but not limited to information under the headings Item 1. "Business," and Item 1A. "Risk Factors" in the Company's Form 10-K for the year ended December 27, 2008, and "Management's Discussion and Analysis of Financial Conditions and Results of Operations" in this Form 10-Q for the quarter ended March 28, 2009. The Company disclaims any intention or obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise.