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 decreased 1% for the three-month period ending September 29, 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 51.5 in September 2012 compared to 52.5 in September 2011. In October 2012, the index was 51.7. This is the second consecutive month of expansion following three months of slight contraction.

Results for the third quarter

(in millions except net income per share)

                             September 29,       October 1,
                                 2012               2011          Increase/Decrease
     Three Months Ended
    Net sales               $          48.8     $       53.0                      -8 %
    Net income              $           8.8     $       11.4                     -23 %
    Net income per share:
    Basic                   $          0.34     $       0.44                     -23 %
    Diluted                 $          0.34     $       0.44                     -23 %

      Nine Months Ended
    Net sales               $         161.1     $      158.5                       2 %
    Net income              $          30.7     $       31.6                      -3 %
    Net income per share:
    Basic                   $          1.19     $       1.23                      -3 %
    Fully Diluted           $          1.18     $       1.23                      -4 %

Third quarter sales were as management expected. The sales decline was driven primarily by Asia/Pacific and Europe. While business was down in these regions, the Company continued to gain new customers to make up for slowing business with existing customers. North America was able to eke out a modest increase in the period. Earnings were within the Company's forecast range, despite being negatively impacted by approximately $0.01 due to taxes.

The Company's product development efforts are ongoing and new products continue to represent between 10 and 15% of sales. The Company has also been working to revamp and enhance its website and expects to launch the new version in early 2013. The new website will be faster, with added configuration mechanisms to make it easier for customers to define and procure solutions.

The fourth quarter forecast reflects continued sluggishness in the macro economy. The PMI is bouncing around the 50 mark, plus or minus, and has yet to provide any clear trend indications either positive or negative. Despite global headwinds, management believes 2012 will be a successful year for Sun. The Company's efforts remain focused on product and market development and providing differentiated solutions and services to its customers.

Outlook

Fourth quarter 2012 revenues are expected to be approximately $41 million, down approximately 10% from the fourth quarter of 2011. Earnings per share are estimated to be $0.22 to $0.24 compared to $0.24 in the same period a year ago.

Management estimates year-end 2012 sales to be approximately $202 million, down approximately 1% from 2011 sales. Earnings per share for 2012 are estimated to be $1.40 to $1.42, compared to $1.46 in 2011.

For comparison purposes, 2011 results included a one-time $0.03 per share gain resulting from the acquisition of HCT.

COMPARISON OF THE THREE MONTHS ENDED SEPTEMBER 29, 2012 AND OCTOBER 1, 2011

Net Sales

Net sales were $48.8 million, a decrease of $4.2 million, or 7.9%, compared to $53.0 million in 2011. The decrease in net sales was primarily driven by weaker demand in our European and Asian end markets, which primarily include capital goods equipment. A price increase, effective July 1, 2012, contributed approximately 3%, or $1.4 million to sales. Changes in exchange rates had a negative impact on sales of approximately 2%, or $0.9 million. New product sales (defined as products introduced within the last five years) continue to make up 10 - 15% of total sales.

North American sales increased 2.4% or $0.6 million, to $25.9 million, Asian sales were down 23.0%, or $2.1 million, to $7.0 million, and European sales were down 17.0%, or $2.8 million, to $13.6 million.

The U.S. reporting segment had sales of $34.3 million in the third quarter of 2012, down $0.6 million or 1.7%, compared to sales of $34.9 million during the third quarter last year. The decrease was driven by weaker demand in all geographic end markets. International sales out of the U.S. were $11.9 million during the third quarter of 2012, down 6.3% or $0.8 million, compared to $12.7 million during the third quarter last year. The decrease in international sales was primarily caused by decreased sales to Europe and Asia.

The Korean reporting segment had sales of $3.5 million during the third quarter of 2012, down $1.6 million or 31.2%, compared to sales of $5.1 million during the third quarter last year. Currency effect had a negative impact of approximately $0.2 million on Korea's third quarter 2012 sales. The remainder of the decrease related to reduced demand within Korea and China.

The German reporting segment had sales of $6.3 million during the third quarter of 2012, down $1.6 million or 19.9%, compared to sales of $7.8 million during the third quarter last year. Currency translation effect due to a weakening Euro had a negative impact on third quarter sales of approximately $0.7 million. The remainder of the decrease primarily related to sales within Germany and to Italy.

The U.K. reporting segment had sales of $4.8 million during the third quarter of 2012, down $0.5 million or 9.1%, compared to sales of $5.2 million during the third quarter last year. The decrease in sales was primarily related to sales to France. Currency effect had a negative impact of approximately $0.1 million on U.K.'s third quarter 2012 sales.

Gross Profit

Gross profit decreased $1.4 million or 6.5% to $19.4 million in the third quarter of 2012, compared to $20.7 million in the third quarter last year. Gross profit as a percentage of net sales increased to 39.7% in the third quarter of 2012, compared to 39.1% in the third quarter last year.

Lower sales volume reduced gross profit by approximately $2.2 million. The remainder of the decrease resulted from higher material costs of approximately $0.6 million, and fixed overhead costs as a percent of sales of $0.5 million. These amounts were partially offset by a price increase in July 2012 of approximately $1.4 million, and reduced variable overhead costs as a percent of sales of $0.7 million, primarily related to reduced overtime and retirement benefit costs.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses increased 18.2%, or $1.0 million, to $6.2 million in 2012, compared to $5.2 million last year. The change for the third quarter of 2012 was primarily due to increased compensation costs of approximately $0.7 resulting from variable compensation to directors, and expenses at HCT of approximately $0.4 million, which were included in the current year. This is the last quarter where HCT's SEA expense will affect year over year comparisons.

Operating Income

Operating income decreased $2.3 million or 14.9% to $13.2 million in the third quarter of 2012, compared to $15.5 million in the third quarter last year, with operating margins of 27.0% and 29.2% for the third quarters of 2012 and 2011, respectively.

The U.S. reporting segment contributed $11.1 million to our consolidated operating income during the third quarter of 2012, compared to $12.1 million during the third quarter of 2011. The decrease of $1.1 million in the U.S. operating segment was primarily related to our fixed cost base. This was partially offset by gains in direct labor and variable overhead.

The Korean reporting segment contributed $0.2 million to our consolidated operating income during the third quarter of 2012 compared to $0.6 million during the third quarter last year. The decrease in operating margins was primarily related to lower sales, fixed costs, and increased material costs.

The German reporting segment contributed $1.3 million to our consolidated operating income during the third quarter of 2012 compared to $2.0 million during the third quarter last year. The decrease in operating margins was primarily related to sales volume and 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 $0.9 million to our consolidated operating income during the third quarters of 2012 and 2011. Operating income decreases from lower sales volume were offset by decreases in material and variable overhead costs.

Interest Income, Net

Net interest income was $0.4 million for the quarter ended September 29, 2012, compared to $0.2 million for the quarter ended October 1, 2011. The Company currently has no outstanding debt. Total average cash and investments for the quarter ended September 29, 2012, was $87.8 million compared to $65.3 million for the quarter ended October 1, 2011.

Miscellaneous Income/Expense, Net

There was minimal net miscellaneous expense for the quarter ended September 29, 2012, compared to net miscellaneous income of $1.3 for the quarter ended October 1, 2011. The prior period amount includes a gain of $1.2 million as a result of remeasuring to fair value the Company's 38% equity interest in HCT held before the business combination.

Income Taxes

The provision for income taxes for the quarter ended September 29, 2012, was 35.0% of pretax income compared to 32.9% for the quarter ended October 1, 2011. For the current period, taxes include discrete items of approximately 1.5% of pretax income related to reserves for uncertain tax positions, which were partially offset by provision to return true-ups. The remaining change relates 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 NINE MONTHS ENDED SEPTEMBER 29, 2012 AND OCTOBER 1, 2011

Net Sales

Net sales were $161.1 million, an increase of $2.6 million, or 1.7%, compared to $158.5 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. Price increases, effective July 1, 2011, and July 1, 2012, contributed approximately 3%, or $5.0 million to sales. Changes in exchange rates had a negative impact on sales of approximately 1.5%, or $2.3 million. New product sales (defined as products introduced within the last five years) continue to make up 10 - 15% of total sales.

North American sales increased 13.2% or $9.4 million, to $80.7 million, Asian sales were down 9.6%, or $3.0 million, to $28.3 million, and European sales were down 8.0%, or $4.0 million, to $46.2 million.

The U.S. reporting segment had sales of $109.4 million in 2012, up $8.9 million or 8.8%, compared to sales of $100.5 million last year. The increase was driven primarily by demand in North American end markets. HCT, acquired in the fourth quarter of 2011, added $2.7 million to sales in 2012. International sales out of the U.S. were $39.6 million in 2012, up 1.2% or $0.5 million, compared to $38.4 million last year. The increase in sales was primarily caused by increased sales to Canada. Sales from the U.S. to Europe remained relatively flat, while sales to Asia decreased from the prior year.

The Korean reporting segment had sales of $14.4 million in 2012, down $2.4 million or 14.2%, compared to sales of $16.8 million last year. Currency effect had a negative impact of approximately $0.6 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 $20.7 million in 2012 down $1.6 million or 7.1%, compared to sales of $22.3 million in 2011. Sales increased slightly 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 $1.6 million.

The U.K. reporting segment had sales of $16.6 million in 2012, down $2.3 million or 12.1%, compared to sales of $18.9 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 $0.2 million.

Gross Profit

Gross profit increased $2.2 million or 3.6% to $64.6 million in 2012, compared to $62.4 million last year. Gross profit as a percentage of net sales increased to 40.1% in 2012, compared to 39.3% last year.

The increase in gross profit was primarily attributed to price increases in July 2011 and 2012, totaling approximately $5.0 million, and decreases in variable overhead costs as a percent of sales primarily related to reduced overtime and retirement benefits. These amounts were partially offset by increased material costs of $1.8 million, labor costs of $0.3 million, fixed overhead costs as a percent of sales of $0.8 million. Additionally, sales volume, excluding pricing, reduced gross profit approximately $0.9 million.

Selling, Engineering and Administrative Expenses

Selling, engineering and administrative expenses increased 11.9%, or $2.1 million, to $19.7 million in 2012, compared to $17.6 million last year. The change for 2012 was primarily due to expenses at HCT of approximately $1.3 million, which were included in the current year, increased compensation costs of $0.8 million, which includes variable director compensation.

Operating Income

Operating income increased $0.1 million or 0.3% to $44.9 million in 2012, compared to $44.8 million last year, with operating margins of 27.9% and 28.3% for 2012 and 2011, respectively.

The U.S. reporting segment contributed $36.0 million to our consolidated operating income during 2012, compared to $33.5 million during 2011. The increase of $2.5 million in the U.S. operating segment was primarily related to the increase in sales volume.

The Korean reporting segment contributed $1.4 million to our consolidated operating income during 2012 compared to $2.2 million last year. The decrease in operating margins was primarily related to reduced sales volume and increased material costs.

The German reporting segment contributed $4.5 million to our consolidated operating income during 2012 compared to $5.7 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 $3.1 million to our consolidated operating income during 2012 compared to $3.4 million last year. The decrease in operating income was primarily related to the decrease in sales volume.

Interest Income, Net

Net interest income was $1.0 million in 2012, compared to $0.6 million in 2011. The Company currently has no outstanding debt. Total average cash and investments for the nine months ended September 29, 2012, was $82.2 million compared to $56.4 million for the nine months ended October 1, 2011.

Miscellaneous Income, Net

There was net miscellaneous income of $0.2 million in 2012, compared to net miscellaneous income of $1.6 million in 2011. The current period income is primarily related to an incentive received for our thermal storage energy building. The prior period includes a gain of $1.2 million as a result of remeasuring to fair value the Company's 38% equity interest in HCT held before the business combination. The prior period also includes the gain recognized on the sale of our China joint venture.

Income Taxes

The provision for income taxes for the nine months ended September 29, 2012, was 33.5% of pretax income compared to 32.7% for the nine months ended October 1, 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. For the current year, taxes include discrete items of approximately 0.5% of pretax income related to reserves for uncertain tax positions, which were partially offset by provision to return true-ups.

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 29, 2012, was $40.1 million, an increase of $2.1 million, compared to $38.0 million for the nine months ended October 1, 2011. Net income was down approximately $0.9 million from the prior period. However, the prior period included a non cash gain on investment of HCT of approximately $1.2 million, which reduced prior period cash from operations. Changes in working capital relating to increases in accounts receivable and inventory were $2.5 million during 2012, compared to $3.8 million during 2011. Increases in accounts payable and accruals were $3.8 million during 2012, compared to $5.1 million during 2011. Cash on hand increased $5.7 million from $45.1 million at the end of 2011 to $50.7 million at September 29, 2012. Days sales outstanding (DSO) were 34 at September 29, 2012, and October 1, 2011. Inventory turns were 9.1 as of September 29, 2012, and 10.7 as of October 1, 2011.

Capital expenditures, consisting primarily of purchases of machinery and equipment, were $6.7 million for the nine months ended September 29, 2012, compared to $6.8 million for the nine months ended October 1, 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 October 15, 2012, to shareholders of record as of September 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 September 29, 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 nine 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 September 29, 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.