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 is down 47% for the three-month period ending September 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). When PMI is over 50, it indicates economic expansion; when it is below 50, it indicates contraction in the economy. The index increased to 52.6 in September 2009 compared to 43.5 in September 2008. In October 2009, the index increased to 55.7. This is the third consecutive month above 50, indicating the economy is expanding. Additionally, the rate of growth is the highest since April 2006. The portion of the index that represents production has been above 50, indicating a growth phase, for the last five months. Management believes these trends are a strong indication that Sun will see growth into 2010.

Results for the third quarter

(Dollars in millions except net income per share)

                             September 26, 2009    September 27, 2008    Decrease

    Three Months Ended
    Net Sales               $               23.3   $              44.8        -48 %
    Net Income              $                0.6   $               6.7        -91 %
    Net Income per share:
    Basic                   $               0.03   $              0.40        -93 %
    Diluted                 $               0.03   $              0.40        -93 %

    Nine Months Ended
    Net Sales               $               70.1   $             145.3        -52 %
    Net Income              $                0.6   $              23.3        -97 %
    Net Income per share:
    Basic                   $               0.03   $              1.40        -98 %
    Fully Diluted           $               0.03   $              1.40        -98 %

The Company experienced a modest rebound in sales and incoming order activity that began in the third quarter. The sequential revenue increase and recognition of the full benefit of the employee furlough programs helped earnings turn positive for the quarter.

Management is cautiously optimistic that the bottom of this recession has passed, as the fourth quarter forecast represents a 12% sequential sales increase in what is historically the weakest quarter of the year.

In addition to PMI, management's optimism is based, in part, on actions it took during this downturn. Investments made now will help reap rewards for Sun in the future. On the product side, the Company's electrically-actuated valves continue to gain attention in the marketplace and HCT (High Country Tek), as a by-product of its sales efforts, continues to uncover new opportunities for Sun products. Prototype development for integrated packages has remained very busy throughout the last three quarters and has led to new orders.

Through this downturn, Sun has been able to keep its workforce intact and the Company has continued to invest in machinery and equipment to improve quality and productivity. New product designs complement Sun's integrated packaging strategy and are helping the Company develop unique system solutions for customers.

Outlook

The Company's 2009 fourth quarter sales are expected to be $26 million, a 21% decrease in revenue compared to last year, and earnings are expected to be $0.05 to $0.07 per share compared to earnings of $0.15 per share in the same period of the prior year.

Sales for the year are estimated to be approximately $96 million, a 46% decrease compared to 2008. Earnings per share for 2009 are estimated to be $0.08 to $0.10 compared to earnings of $1.55 per share in 2008.

Sun's fourth quarter results are based on a 14-week quarter resulting in a 53-week year for 2009. This will result in approximately three additional shipping days.

COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 26, 2009 AND SEPTEMBER 27, 2008

Net Sales

Net sales were $23.3 million, a decrease of $21.5 million, or 47.9%, compared to $44.8 million in 2008. Net sales decreased 45.4% 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 10 - 15% of total sales.

North American sales decreased 50.0% or $10.5 million, to $10.5 million, Asian sales decreased 40.5% or $3.0 million, to $4.4 million, and European sales decreased 49.2% or $7.4 million, to $7.6 million.

The U.S. reporting segment had sales of $13.9 million in the third quarter of 2009, down $14.9 million or 51.8%, compared to sales of $28.8 million during the third 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 $4.2 million during the third quarter of 2009, down 57.5% or $5.7 million, compared to $9.9 million during the third quarter last year. Significant decreases in sales were noted in almost all geographic regions.

The Korean reporting segment had sales of $2.6 million during the third quarter of 2009, down $1.2 million or 32.0%, compared to sales of $3.9 million during the third quarter last year. Currency effect reduced 2009 third quarter sales by approximately $0.5 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 $3.4 million during the third quarter of 2009, down $3.3 million or 49.2%, compared to sales of $6.7 million during the third quarter last year. Currency effect reduced 2009 third quarter sales by approximately $0.2 million. The remaining decrease was primarily related to demand within Germany. However, sales were down in almost all geographic markets.

The U.K. reporting segment had sales of $3.4 million during the third quarter of 2009, down $2.0 million or 37.0%, compared to sales of $5.4 million during the third quarter last year. Currency effect reduced 2009 third quarter sales by approximately $0.3 million. The largest reduction of sales was to customers within the U.K. However, sales were down in almost all geographic markets.

Gross Profit

Gross profit decreased $9.4 million or 63.7% to $5.4 million in the third quarter of 2009, compared to $14.7 million in the third quarter last year. Gross profit as a percentage of net sales decreased to 22.9% in the third quarter of 2009, compared to 32.9% in the third quarter last year. The Company experienced a sharp decline in sales during the fourth quarter of 2008, which began the downward trend in gross profit margins. Sales continued to decline in the first half of 2009, resulting in further reductions in the gross profit margin. Sales have since increased sequentially in the third quarter. The increased sales coupled with changes in our production resources has resulted in a higher gross profit margin sequentially.

Third quarter gross profit decreases compared to the same period of the prior year were primarily related to lower sales volume, which contributed $7.1 million of the decrease. The remaining decreases in gross profit were attributed to productivity declines of approximately $0.3 million, and increases in overhead expenses as a percentage of sales of approximately $2.7 million, both of which occurred primarily in the U.S. In periods of sharp declining sales, the Company cannot reduce costs at the same pace. However, the decrease in gross profit was partially offset by lower material costs as a percent of sales of approximately $0.6 million and the elimination of overtime premiums of approximately $0.3 million. These reductions were primarily in the U.S.

In June 2009, the Company initiated rolling furloughs for the production workforce and a 3% salary reduction for non-production personnel. While the decision was not cost driven, the Company did experience cost savings of approximately $0.7 million in the third quarter.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses decreased 9.7%, or $0.5 million, to $4.9 million compared to the same quarter last year. The Company did not experience any significant decreases in any one particular category, but did see decreases in almost all areas.

Operating Income

Operating income decreased $8.9 million or 95.4% to $0.4 million in the third quarter of 2009, compared to $9.3 million in the third quarter last year, with operating margins of 1.8% and 20.7% for the third quarters of 2009 and 2008, respectively. The sharp decline in sales is the primary cause for the operating income decline. 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 $0.3 million in the third quarter of 2009, compared to operating income of $6.2 million during the third quarter of 2008, a decrease of $6.5 million. The sharp decline in sales volume reduced operating income $3.2 million. The remaining decrease in operating income occurred from productivity declines as a result of keeping the Company's workforce intact, and increased variable and fixed overhead costs as a percent of sales. Decreases in operating income were partially offset by decreases in material costs, salaries and fringe benefits, and overtime premiums. Additionally, the Company had cost savings of approximately $0.8 million during the third quarter, as a result of the furloughs and salary reductions. The Company continues to monitor and reduce fixed costs where it is deemed appropriate.

The Korean reporting segment contributed $0.2 million to our consolidated operating income during the third quarter of 2009 compared to $0.3 million during the third quarter last year, a decrease of $0.1 million. The reduction in sales volume was responsible for the decrease in operating income.

The German reporting segment contributed $0.5 million to our consolidated operating income during the third quarter of 2009 compared to $2.1 million during the third quarter last year, a decrease of $1.6 million. Reduction in sales volume resulted in a decrease of $1.0 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 less than $0.1 million to our consolidated operating income during the third quarter of 2009 compared to $0.8 million during the third quarter last year, a decrease of $0.7 million. The reduction in sales volume was responsible for $0.3 million of the decrease in operating income. The remaining decrease was primarily related to increases in overhead costs as a percent of sales and increased material costs.

Interest Income, Net

Net interest income was $0.1 million for the quarter ended September 26, 2009, compared to $0.2 million for the quarter ended September 27, 2008. The Company currently has no outstanding debt compared to $0.5 million the prior year. Total average cash and investments for the quarter ended September 26, 2009, was $35.7 million compared to $30.7 million for the quarter ended September 27, 2008. Although average cash increased, interest income decreased due to lower interest rates compared to the prior year.

Foreign Currency Transaction Gain, Net

There was a net foreign currency transaction gain of $0.1 million for the quarter ended September 26, 2009, compared to $0.3 million for the quarter ended September 27, 2008. The British Pound, Euro and

Korean Won all made gains against the U.S. Dollar during the period. The prior period gain was primarily due to the strengthening of the U.S. Dollar against the British Pound, and the revaluation of assets and liabilities held in U.S. Dollars at our U.K. subsidiary.

Miscellaneous (Income) Expense, Net

There was net miscellaneous expense of $0.1 for the quarter ended September 26, 2009, compared to a minimal expense for the quarter ended September 27, 2008. The net miscellaneous expense is primarily made up of earnings and losses from joint ventures.

Income Taxes

The provision for income taxes for the quarter ended September 26, 2009, was 2.8% of pretax income compared to 31.8% of pretax income for the quarter ended September 27, 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. Additionally, the current period provision was affected by discrete items related to the return-to-provision true-up upon completion of the 2008 U.S. return and adjustments related to R&D tax credit calculations. Excluding these discrete items, the effective rate would have been approximately 29.0%.

COMPARISON OF THE NINE MONTHS ENDED SEPTEMBER 26, 2009 AND SEPTEMBER 27, 2008

Net Sales

Net sales were $70.1 million, a decrease of $75.2 million, or 51.7%, compared to $145.3 million in 2008. Net sales decreased 47.6% 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 10 - 15% of total sales.

North American sales decreased 51.9% or $34.1 million, to $31.7 million, Asian sales decreased 55.0% or $14.8 million, to $12.1 million, and European sales decreased 50.6% or $24.8 million, to $24.2 million.

The U.S. reporting segment had sales of $42.1 million in the period ended September 26, 2009, down $46.8 million or 52.6%, compared to sales of $88.8 million during the period ended September 27, 2008. 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 $13.3 million during 2009, down 56.1% or $17.0 million, compared to $30.3 million during the prior year. Significant decreases in sales were noted in almost all geographic regions.

The Korean reporting segment had sales of $7.0 million during the period ended September 26,2009, down $8.7 million or 55.6%, compared to sales of $15.7 million during period ended September 27, 2008 . Currency effect reduced 2009 sales by approximately $1.9 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 $11.0 million during the period ended September 26, 2009, down $11.5 million or 51.1%, compared to sales of $22.6 million during the period ended September 27, 2008. Currency effect reduced 2009 sales by approximately $1.4 million. The remaining decrease was primarily related to demand within Germany. However, sales were down in all geographic markets.

The U.K. reporting segment had sales of $10.0 million during the period ended September 26, 2009, down $8.2 million or 45.0%, compared to sales of $18.3 million during the period ended September 27, 2008. Currency effect reduced 2009 sales by approximately $1.4 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 $35.7 million or 70.2% to $15.2 million in the period ended September 26, 2009, compared to $50.9 million in the period ended September 27, 2008. Gross profit as a percentage of net sales decreased to 21.6% in the period ended September 26, 2009, compared to 35.0% in the period ended September 27, 2008. 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 during the first half of 2009, resulting in further reductions in the gross profit margin. Margins have begun to increase in the third quarter of 2009.

The 2009 gross profit decreases were primarily related to lower sales volume, which contributed $26.4 million of the decrease. The remaining decreases in gross profit were attributed to productivity declines of approximately $2.5 million, and increases in overhead expenses as a percentage of sales of approximately $8.7 million, both of which occurred primarily in the U.S. In periods of sharp declining sales, the Company cannot reduce costs at the same pace. However, the decrease in gross profit was partially offset by lower material costs as a percent of sales of approximately $1.6 million, primarily in the U.S. Additionally, the Company eliminated overtime premiums equal to approximately $1.1 million, reduced retirement benefits primarily related to the shared distribution of approximately $1.6 million that was included in the prior year results, and reduced health benefit costs of $0.5 million. These reductions were all primarily in the U.S. Additionally, the Company had cost savings of approximately $0.9 for the period ended September 26, 2009, resulting from the furloughs and salary reductions.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses decreased 15.3%, or $2.6 million, to $14.6 million compared to the same period last year. The change was due to decreases in compensation of $0.9 million, resulting primarily from salary freezes and reductions that began in January, fringe benefit costs of $0.5 million, primarily related to retirement benefits associated with the shared distribution that was included in the prior year results, and travel of $0.3 million.

Operating Income

Operating income decreased $33.1 million or 98.2% to $0.6 million in the period ended September 26, 2009, compared to $33.7 million in the period ended September 27, 2008, with operating margins of 0.8% and 23.2% for 2009 and 2008, respectively. The sharp decline in sales was 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. Therefore, at the current sales levels, it is difficult for all reporting segments to absorb their fixed costs.

The U.S. reporting segment experienced an operating loss of $2.4 million in the period ended September 26, 2009, compared to operating income of $22.8 million during the period ended September 27, 2008, a decrease of $25.2 million. The sharp decline in sales volume reduced operating income $12.0 million. Additional 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. Decreases in operating income were partially offset by decreases in material costs. Additionally, the Company had cost savings of approximately $1.0 million for the period ending September 26, 2009, as a result of the furloughs and salary reductions.

The Korean reporting segment contributed $0.4 million to our consolidated operating income during the period ended September 26, 2009 compared to $1.3 million during the period ended September 27, 2008, a decrease of $0.9 million. The reduction in sales volume was responsible for $0.7 million of the decrease in operating income.

The German reporting segment contributed $1.8 million to our consolidated operating income during the period ended September 26, 2009 compared to $6.9 million during the period ended September 27, 2008, a decrease of $5.1 million. Reduction in sales volume resulted in a decrease of $3.5 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, and increased fixed overhead costs as a percent of sales.

The U.K. reporting segment contributed $0.6 million to our consolidated operating income during the period ended September 26, 2009, compared to $2.9 million during the period ended September 27, 2008, a decrease of $2.3 million. The reduction in sales volume was responsible for $1.3 million of the decrease in operating income. The remaining decrease was primarily related to increased fixed overhead costs as a percent of sales.

Interest Income, Net

Net interest income was $0.4 million for the period ended September 26, 2009, compared to $0.5 million for the period ended September 27, 2008. The Company currently has no outstanding debt compared to $0.6 million the prior year. Total average cash and investments for the nine months ended September 26, 2009, was $36.5 million compared to $26.3 million for the nine months ended September 27, 2008. Although average cash increased, interest income decreased due to lower interest rates compared to the prior year.

Foreign Currency Transaction (Gain) Loss, Net

There was a net foreign currency transaction loss of $0.2 million for the period ended September 26, 2009, compared to a net gain of $0.2 million for the period ended September 27, 2008. While the Euro, the Korean Won and the British Pound all strengthened against the U.S. Dollar, the UK operations experienced losses related to sales conducted in U.S. dollars and from the revaluation of Sun Ltd. balance sheet items, which were held in U.S. dollars. The inverse was true of the prior year period.

Miscellaneous (Income)/Expense, Net

There was net miscellaneous expense of $0.4 million for the period ended September 26, 2009, compared to $0.2 million of net miscellaneous income for the period ended September 27, 2008. Net miscellaneous (income)/expense is primarily made up of earnings and losses from joint ventures. The prior year income includes proceeds from an insurance claim.

Income Taxes

The provision for income taxes for the period ended September 26, 2009, was a benefit of 45.9% of pretax income compared to a provision of 32.7% for the period ended September 27, 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 nine months ended September 26, 2009, was $11.3 million, compared to $30.8 million for the nine months ended September 27, 2008. The $19.5 million decrease in the Company's net cash flow from operations during the period was due primarily to the decrease in net income of $22.7 million, change in taxes payable/receivable of $0.8 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 $3.7 million compared to increases in the prior year totaling $1.9 million partially offset the reduction in operating cash flows. Cash on hand decreased $5.1 million from $35.3 million in 2008 to $30.2 million in 2009. However, this decrease was largely the result of net purchases of marketable securities totaling $7.5 million. Days sales outstanding (DSO) were 42 and 38 at September 26, 2009, and September 27, 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 8.9 as of September 26, 2009, compared to 10.4 as of September 27, 2008.

Capital expenditures were $4.5 million for the nine months ended September 26, 2009, compared to $9.2 million for the nine months ended September 27, 2008. The current year includes purchases of machinery and equipment of $2.8 million and a land purchase of $1.7 million. The prior year includes purchases of machinery and equipment of $6.7 million and a land purchase of $2.5 million. The parcels of land along with already owned property that includes one of the Companies existing facilities combine to provide the Company with 27 contiguous acres. It provides the Company with excellent options if it determines that additional bricks and mortar are needed. Capital expenditures for the year are projected to be approximately $6.5 million.

The Company declared a quarterly dividend of $0.09 per share to shareholders of record as of September 30, 2009, payable on October 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 . . .