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 31, 2011, were approximately 60% 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 24% and 42% in 2011 and 2010, respectively, after a decrease of 40% in 2009. The index of shipments of hydraulic products increased 6% for the three-month period ending June 30, 2012, 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 in the manufacturing sector; when it is below 50, it indicates contraction. The index decreased to 49.7 in June 2012 compared to 55.3 in June 2011. In July 2012, the index was 49.8. This is the second consecutive month of contraction in the manufacturing sector, following 34 months of expansion.

Results for the second quarter

(in millions except net income per share)

                                       June 30,      July 2,
                                         2012          2011       Increase

               Three Months Ended
              Net sales               $     57.0     $   54.8             4 %
              Net income              $     11.2     $   10.4             8 %
              Net income per share:
              Basic                   $     0.43     $   0.41             5 %
              Diluted                 $     0.43     $   0.41             5 %

                Six Months Ended
              Net sales               $    112.3     $  105.5             6 %
              Net income              $     21.9     $   20.2             8 %
              Net income per share:
              Basic                   $     0.85     $   0.79             8 %
              Fully Diluted           $     0.84     $   0.79             6 %

Sun had another record quarter with sales of $57 million. Second quarter sales were up 4%, despite a 2% negative impact due to the strengthening of the U.S. dollar. Strong domestic demand continued to drive the top line, with year-to-date North American sales up 19% compared to last year. Despite emerging headwinds, Sun had a strong first half and is on track to have another great year of sales and earnings.

Sun's international business slowed in the second quarter, primarily in Europe. While the European economy struggles and China's growth remains constrained, the Company continues to add new customers, enlarging its customer base in these regions. Management believes long-term, this market penetration will help bolster Sun's global market share.

This is a period of economic volatility and it is difficult to anticipate short-term business conditions in this environment. The PMI, which came in at 49.8 for July 2012, supports the idea of short-term uncertainty. But, Sun is a very agile company and, as we have demonstrated in the past, we are able to rapidly flex and adapt to changing business conditions. The Company's focus remains on long-term profitable growth by providing both products and services that its customers value. Management believes this is the best way to achieve better than average returns for its shareholders.

Outlook

All geographic regions continue to moderately slow down and third quarter 2012 revenues are expected to be approximately $49 million, compared to $53 million in the third quarter of 2011. For comparison purposes, the third quarter 2012 outlook includes $1 million in revenue from High Country Tek (HCT), while there was no revenue impact in 2011's third quarter results from HCT.

Third quarter 2012 earnings per share are estimated to be $0.34 to $0.36, compared to $0.44 in the same period a year ago. HCT is not expected to contribute to 2012 earnings. However, for comparison purposes, 2011 third quarter results included a one-time $0.03 per share gain resulting from the acquisition of HCT. The remainder of the earnings decline is predominantly related to lower sales volume.

COMPARISON OF THE THREE MONTHS ENDED JUNE 30, 2012 AND JULY 2, 2011

Net Sales

Net sales were $57.0 million, an increase of $2.3 million, or 4.1%, compared to $54.8 million in 2011. The increase in net sales was primarily driven by increased demand in North America in our end markets, which primarily include capital goods equipment. A price increase, effective July 1, 2011, contributed approximately 3%, or $1.8 million to sales. Changes in exchange rates had a negative impact on sales of approximately 2%, or $1.0 million. New product sales (defined as products introduced within the last five years) continue to make up 10 - 12% of total sales.

North American sales increased 17.7% or $4.3 million, to $28.6 million, Asian sales were down 6.2%, or $0.7 million, to $10.6 million, and European sales were down 6.5%, or $1.1 million, to $15.9 million.

The U.S. reporting segment had sales of $39.5 million in the second quarter of 2012, up $4.3 million or 12.3%, compared to sales of $35.2 million during the second quarter last year. The increase was driven primarily by demand in the North American market. HCT, acquired in the fourth quarter of 2011, added $1.0 million to sales in the second quarter of 2012. International sales out of the U.S. were $14.7 million during the second quarter of 2012, up 4.7% or $0.7 million, compared to $14.0 million during the second quarter last year. The increase in international sales was primarily caused by increased sales to Canada, while sales to Europe and Asia remained relatively flat.

The Korean reporting segment had sales of $5.0 million during the second quarter of 2012, down $0.7 million or 12.7%, compared to sales of $5.7 million during the second quarter last year. Currency effect had a negative impact of approximately $0.3 million on Korea's second quarter 2012 sales. The remainder of the decrease related to reduced demand within Korea and China.

The German reporting segment had sales of $7.1 million during the second quarter of 2012, down $0.3 million or 3.5%, compared to sales of $7.3 million during the second quarter last year. Sales increased in local currency compared to the prior year, but currency translation effect due to a weakening Euro had a negative impact on second quarter sales of approximately $0.7 million.

The U.K. reporting segment had sales of $5.6 million during the second quarter of 2012, down $1.1 million or 16.1%, compared to sales of $6.6 million during the second quarter last year. The decrease in sales was primarily related to reduced demand within the UK and to France. Currency effect had a negative impact of approximately $0.1 million on U.K.'s second quarter 2012 sales.

Gross Profit

Gross profit increased $1.3 million or 6.0% to $23.0 million in the second quarter of 2012, compared to $21.7 million in the second quarter last year. Gross profit as a percentage of net sales increased to 40.3% in the second quarter of 2012, compared to 39.6% in the second quarter last year.

The increase in gross profit was primarily attributed to a price increase in July 2011 of approximately $1.8 million. Higher sales volume in the second quarter of 2012 contributed $0.2 million of the increase. These amounts were partially offset by higher material, direct labor and fixed overhead costs, all of which increased approximately $0.2 million.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses increased 3.4%, or $0.2 million, to $6.5 million in 2012, compared to $6.3 million last year. The change for the second quarter of 2012 was primarily due to expenses at HCT of approximately $0.4 million, which were included in the current year. HCT's SEA expenses add approximately $0.5 million next quarter, affecting year over year comparisons.

Operating Income

Operating income increased $1.1 million or 7.0% to $16.5 million in the second quarter of 2012, compared to $15.4 million in the second quarter last year, with operating margins of 28.9% and 28.1% for the second quarters of 2012 and 2011, respectively.

The U.S. reporting segment contributed $13.1 million to our consolidated operating income during the second quarter of 2012, compared to $11.4 million during the second quarter of 2011. The increase of $1.7 million in the U.S. operating segment was primarily related to the increase in sales volume.

The Korean reporting segment contributed $0.5 million to our consolidated operating income during the second quarter of 2012 compared to $0.7 million during the second quarter last year. The decrease in operating margins was primarily related to lower sales and increased material costs.

The German reporting segment contributed $1.6 million to our consolidated operating income during the second quarter of 2012 compared to $1.9 million during the second quarter last year. The decrease in operating margins was primarily related to increased material costs. Material cost increases were related to purchases of material in U.S. Dollars and a weakening Euro.

The U.K. reporting segment contributed $1.1 million to our consolidated operating income during the second quarter of 2012 compared to $1.3 million during the second quarter last year. The decrease in operating income was primarily related to the decrease in sales volume.

Interest Income, Net

Net interest income was $0.3 million for the quarter ended June 30, 2012, compared to $0.2 million for the quarter ended July 2, 2011. The Company currently has no outstanding debt. Total average cash and investments for the quarter ended June 30, 2012, was $81.9 million compared to $52.0 million for the quarter ended July 2, 2011.

Miscellaneous Income/Expense, Net

There was minimal net miscellaneous income for the quarters ended June 30, 2012, compared to minimal net miscellaneous expense for the quarter ended July 2, 2011.

Income Taxes

The provision for income taxes for the quarter ended June 30, 2012, was 33.3% of pretax income compared to 33.0% for the quarter ended July 2, 2011. 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.

COMPARISON OF THE SIX MONTHS ENDED JUNE 30, 2012 AND JULY 2, 2011

Net Sales

Net sales were $112.3 million, an increase of $6.8 million, or 6.5%, compared to $105.5 million in 2011. The increase in net sales was primarily driven by increased demand in North America in our end markets, which primarily include capital goods equipment. A price increase, effective July 1, 2011, contributed approximately 3%, or $3.6 million to sales. Changes in exchange rates had a negative impact on sales of approximately 1%, or $1.4 million. New product sales (defined as products introduced within the last five years) continue to make up 10 - 12% of total sales.

North American sales increased 19.1% or $8.8 million, to $54.8 million, Asian sales were down 4.1%, or $0.9 million, to $21.2 million, and European sales were down 3.6%, or $1.2 million, to $32.6 million.

The U.S. reporting segment had sales of $75.1 million in 2012, up $9.5 million or 14.4%, compared to sales of $65.6 million last year. The increase was driven primarily by demand in North American end markets. HCT, acquired in the fourth quarter of 2011, added $1.9 million to sales in 2012. International sales out of the U.S. were $27.6 million in 2012, up 7.4% or $1.9 million, compared to $25.7 million last year. The increase in sales was primarily caused by increased sales to Canada. Sales from the U.S. to Europe also increased slightly compared to the prior year, while sales to Asia remained relatively flat.

The Korean reporting segment had sales of $10.9 million in 2012, down $0.8 million or 6.8%, compared to sales of $11.7 million last year. Currency effect had a negative impact of approximately $0.4 million on Korea's 2012 sales. The remainder of the decrease related to reduced demand within Korea and China.

The German reporting segment had sales of $14.5 million in both 2012 and 2011. Sales increased in local currency compared to the prior year, but currency translation effect due to a weakening Euro had a negative impact on 2012 sales of approximately $0.9 million.

The U.K. reporting segment had sales of $11.8 million in 2012, down $1.8 million or 13.3%, compared to sales of $13.7 million last year. The decrease in sales was primarily related to reduced demand relating to a onetime project in the U.K. last year, which contributed approximately $2.0 million to sales in 2011 that did not occur during the current period. There was a negative impact from currency on the U.K.'s 2012 sales of $0.1 million.

Gross Profit

Gross profit increased $3.6 million or 8.6% to $45.2 million in 2012, compared to $41.6 million last year. Gross profit as a percentage of net sales increased to 40.2% in 2012, compared to 39.5% last year.

The increase in gross profit was primarily attributed to a price increase in July 2011 of approximately $3.6 million. Higher sales volume in 2012 contributed $1.3 million of the increase. Decreases in overhead expenses as a percentage of sales added approximately $0.2 million to gross profit. These amounts were partially offset by increased material costs of $1.2 million, and increased labor costs of $0.2 million.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses increased 9.2%, or $1.1 million, to $13.5 million in 2012, compared to $12.3 million last year. The change for 2012 was primarily due to expenses at HCT of approximately $0.9 million, which were included in the current year. HCT's SEA expenses will add approximately $0.5 million next quarter, affecting year over year comparisons.

Operating Income

Operating income increased $2.4 million or 8.3% to $31.7 million in 2012, compared to $29.3 million last year, with operating margins of 28.3% and 27.8% for 2012 and 2011, respectively.

The U.S. reporting segment contributed $24.9 million to our consolidated operating income during 2012, compared to $21.4 million during 2011. The increase of $3.5 million in the U.S. operating segment was primarily related to the increase in sales volume.

The Korean reporting segment contributed $1.2 million to our consolidated operating income during 2012 compared to $1.6 million last year. The decrease in operating margins was primarily related to increased material costs.

The German reporting segment contributed $3.2 million to our consolidated operating income during 2012 compared to $3.7 million last year. The decrease in operating margins was primarily related to increased material costs. Material cost increases were related to purchases of material in U.S. Dollars and a weakening Euro.

The U.K. reporting segment contributed $2.2 million to our consolidated operating income during 2012 compared to $2.5 million last year. The decrease in operating income was primarily related to the decrease in sales volume.

Interest Income, Net

Net interest income was $0.6 million in 2012, compared to $0.3 million in 2011. The Company currently has no outstanding debt. Total average cash and investments for the six months ended June 30, 2012, was $78.8 million compared to $53.8 million for the six months ended July 2, 2011.

Miscellaneous Income, Net

There was net miscellaneous income of $0.2 million in 2012, compared to net miscellaneous income of $0.3 million in 2011. The current period income is primarily related to an incentive received for our thermal storage energy building, and the prior period includes the gain recognized on the sale of our China joint venture.

Income Taxes

The provision for income taxes for the six months ended June 30, 2012, was 32.9% of pretax income compared to 32.6% for the six months ended July 2, 2011. 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.

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 six months ended June 30, 2012, was $23.8 million, compared to $22.0 million for the six months ended July 2, 2011. The $1.8 million increase in the Company's net cash flow from operations during the period was due primarily to the increase in net income of $1.7 million. Changes in working capital relating to increases in accounts receivable and inventory were $6.4 million during 2012, compared to $8.2 million during 2011. Increases in accounts payable and accruals were $3.2 million during 2012, compared to $5.4 million during 2011. Cash on hand increased $2.2 million from $51.3 million at the end of 2011 to $53.5 million at June 30, 2012. Days sales outstanding (DSO) were 35 and 39 at June 30, 2012, and July 2, 2011. Inventory turns were 9.9 as of June 30, 2012, and 11.0 as of July 2, 2011.

Capital expenditures, consisting primarily of purchases of machinery and equipment, were $4.8 million for the six months ended June 30, 2012, compared to $2.8 million for the six months ended July 2, 2011. Capital expenditures for the year are projected to be approximately $13.0 million.

In January 2012, the Company applied for permitting to begin site preparation for a planned expansion on property the Company currently owns. The new facility, when completed, will have 60,000 square feet of manufacturing and 16,000 square feet of office space. The total investment is estimated to be approximately $16.0 million.

Included in capital expenditures for 2012 is approximately $6.0 million relating to the new facility. Also included in our annual estimate is $2.0 million for an expansion and update of our U.K. facility. The remaining expenditures consist of purchases of machinery and equipment.

The Company declared a quarterly cash dividend of $0.09 per share payable on July 15, 2012, to shareholders of record as of June 30, 2012. 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 does not engage in any off balance sheet financing arrangements. In particular, the Company does not have any material interest in variable interest entities, which include special purpose entities and structured finance entities.

The Company uses the equity method of accounting to account for its investment in WhiteOak. The Company does not have a majority ownership in or exercise control over the entity. The investment was not material to the financial statements of the Company at June 30, 2012.

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. The Company's second quarter net sales, income from operations and net income historically are the highest of any quarter during the year.

Inflation

The impact of inflation on the Company's operating results has been moderate in recent years, reflecting generally lower rates of inflation in the economy. 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, inventory, goodwill, accruals, and income taxes. The Company's critical accounting policies and estimates are included in its Annual Report on Form 10-K for the year ended December 31, 2011, and did not change during the first six months of 2012.

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 costs, 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 31, 2011, and "Management's Discussion and Analysis of Financial Conditions and Results of Operations" in this Form 10-Q for the quarter ended June 30, 2012. 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.