Overview

General

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

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

In support of the above strategy, the Company has been making capital investments in Oil Field to increase manufacturing capacity and capabilities in its three main manufacturing facilities in Lufkin, Texas, Canada and Argentina. These investments should reduce production lead times, improve quality and reduce manufacturing costs. Investments also continue to be made to expand the Company's presence in automation products and international service. During the first quarter of 2009, the Company purchased International Lift Systems ("ILS"), which manufactures and services gas lift, plunger lift and completion equipment for the oil and gas industry. In Power Transmission, the Company continues to expand its gear repair network by opening and expanding facilities in various locations in the U.S. and Canada. The Company is making targeted capital investments in the U.S. and France to expand capacity and reduce manufacturing lead times as well as certain capital investments targeting cost reductions.

Trends/Outlook

Oil Field
Demand for artificial lift equipment primarily depends on the level of new onshore oil well, workover drilling activity as well as the depth and fluid conditions of that drilling and general field maintenance budgets. Drilling activity is driven by the available cash flow of the Company's customers as well as their long-term perceptions of the level and stability of the price of oil. Increasing energy prices from 2004 to late 2008 increased the demand for pumping units and related service and products from higher drilling activity, activation of idle wells and the upgrading of existing wells. During the first nine months of 2008, demand levels in North America increased over the levels experienced in 2007 as higher energy prices drove increased drilling and workover activity. Additionally, the demand for pumping units, oilfield services and automation equipment continued to increase in international markets and the partial recapture of market share from imported equipment.

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

These negative trends continued in the first quarter of 2009 as E&P companies deferred or cancelled drilling programs and reduced field spending in response to lower energy prices. This trend has been more pronounced in North America than in international markets. E&P companies have indicated that drilling activity will not be reactivated until energy prices stabilize at economically viable levels and drilling and service costs decrease. Gross margin levels will be negatively impacted from customer pricing pressure and from reduced plant utilizations.

While the market is suffering a cyclical decline, the Company continues to believe that there are long-term positive growth trends for artificial lift equipment, and as existing fields mature, the market will require an increased use of artificial lift, especially in the South American, Russian and Middle Eastern markets. The acquisition of ILS is consistent with the company's long-term growth strategy of integrating strategic assets to leverage Lufkin's position of industry leadership. ILS has a solid reputation for high-quality products, customer responsiveness and long-standing relationships with major independent and super-major integrated companies. This provides an entry for Lufkin into the offshore market for artificial lift wells, including deepwater plays, and expanded reach into the artificial lift market.

Power Transmission
Power Transmission services many diverse markets, with high-speed gearing for markets such as petrochemicals, refineries, offshore production and transmission of oil and slow-speed gearing for the gas, rubber, sugar, paper, steel, plastics, mining, cement and marine propulsion, each of which has its own unique set of drivers. Generally, if global industrial capacity utilizations are not high, spending on new equipment lags. Also impacting demand are government regulations involving safety and environmental issues that can require capital spending. Recent market demand increases have come from energy-related markets such as refining, petrochemical, drilling, coal, marine and power generation in response to higher global energy prices. Recent declines in energy prices and restricted credit markets have started to impact demand as plans for large energy infrastructure projects are being deferred or cancelled. However, governments are increasing funding for infrastructure and alternative energy projects for economic stimulus purposes, which may create opportunities for power transmission products.

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

Other
During the first quarter of 2009, the Company recorded an additional contingent liability provision of $3.0 million (pre-tax) for its ongoing class-action lawsuit. See Item 1 in Part II for additional information.

Summary of Results

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

Overall, sales for the three months ended March 31, 2009, increased to $153.1 million from $141.1 million for the three months ended March 31, 2008, or 8.6%. This increase was primarily driven by increased sales of oil field products and services in the U.S. market, but also from continued growth in power transmission sales.

Gross margin for the three months ended March 31, 2009, decreased to 22.3% from 28.7% for the three months ended March 31, 2008. This gross margin decrease was primarily related to price decreases in response to material price decreases and lower demand and the negative impact of lower plant utilization on fixed cost coverage in the Oil Field segment. Additional segment data on gross margin is provided later in this section.

Higher selling, general and administrative expenses also negatively impacted net earnings, with these expenses increasing to $18.4 million during the first quarter of 2009 from $17.5 million during the first quarter of 2008. This increase was primarily related to higher divisional spending to support higher sales volume in 2008. However, as a percentage of sales, selling, general and administrative expenses remained at 12%. Operating income was also impacted by a litigation reserve of $3.0 million related to its ongoing class-action lawsuit.

The Company reported net earnings from continuing operations of $9.1 million or $0.60 per share (diluted) for the three months ended March 31, 2009, compared to net earnings from continuing operations of $15.6 million or $1.05 per share (diluted) for the three months ended March 31, 2008.

Debt/equity (long-term debt net of current portion as a percentage of total equity) levels were 1.4% as of March 31, 2009, from 0.0% at December 31, 2008. Cash balances at March 31, 2009, were $92.5 million, down from $107.8 million at December 31, 2008.

Three Months Ended March 31, 2009, Compared to Three Months Ended March 31, 2008

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

                               Three Months Ended
                                    March 31,             Increase/       % Increase/
                               2009          2008        (Decrease)       (Decrease)
        Sales
        Oil Field            $ 111,683     $ 100,909     $    10,774              10.7
        Power Transmission      41,455        40,161           1,294               3.2
        Total                $ 153,138     $ 141,070     $    12,068               8.6

        Gross Profit
        Oil Field            $  23,329     $  28,230     $    (4,901 )           (17.4 )
        Power Transmission      10,854        12,188          (1,334 )           (10.9 )
        Adjustment*                  -           102            (102 )          (100.0 )
        Total                $  34,183     $  40,520     $    (6,337 )           (15.6 )

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

Oil Field

Oil Field sales increased to $111.7 million, or 10.7%, for the three months ended March 31, 2009, from $100.9 million for the three months ended March 31, 2008. New unit sales of $68.8 million during the first quarter of 2009 were up $13.1 million, or 23.4%, compared to $55.7 million during the first quarter 2008, primarily from higher U.S. demand. Although first quarter 2009 U.S. demand increased from first quarter 2008 overall U.S. demand from fourth quarter 2008 decreased. Service sales of $22.0 million during the first quarter of 2009 were up $1.0 million, or 4.7%, compared to $21.0 million during the first quarter 2008, from growth in the U.S. market. Automation sales of $15.6 million during the first quarter of 2009 were down $2.7 million, or 14.9%, compared to $18.4 million during the first quarter 2008, from lower sales in Canada and Argentina. Commercial casting sales of $3.4 million during the first quarter of 2009 were down $2.5 million, or 42.4%, compared to $5.9 million during the first quarter 2008, from lower sales to the machine tool market. Sales from Lufkin ILS contributed $2.0 million during the first quarter of 2009. Oil Field's backlog decreased to $93.3 million as of March 31, 2009, from $97.1 million at March 31, 2008, and $188.1 million at December 31, 2008. This decrease was caused primarily by lower orders for new pumping units as customers deferred or cancelled drilling programs in response to lower energy prices.

Gross margin (gross profit as a percentage of sales) for the Oil Field segment decreased to 20.9% for three months ended March 31, 2009, compared to 28.0% for the three months ended March 31, 2008, or 7.1 percentage points. This gross margin decrease was related to price reductions in response to material price decreases and lower customer demand and the negative impact of lower plant utilization on fixed cost coverage.

Direct selling, general and administrative expenses for Oil Field increased to $6.2 million, or 24.6%, for the three months ended March 31, 2009, from $5.0 million for the three months ended March 31, 2008. This increase was due to higher employee-related expenses in support of increased sales volumes in 2009. Direct selling, general and administrative expenses as a percentage of sales increased to 5.5% for the three months ended March 31, 2009, from 4.9% for the three months ended March 31, 2008.

Power Transmission

Sales for the Company's Power Transmission segment increased to $41.5 million, or 3.2%, for the three months ended March 31, 2009, compared to $40.2 million for the three months ended March 31, 2008. New unit sales of $33.1 million during the first quarter of 2009 were up $1.6 million, or 4.9%, compared to $31.5 million during the first quarter of 2008 from increased sales of marine units for the coastal, river and inland-waterway transportation markets. Repair and service sales of $8.4 million during the first quarter of 2009 were down $0.2 million, or 3.0%, compared to $8.6 million during the first quarter 2008. Power Transmission backlog at March 31, 2009, decreased to $114.7 million from $137.6 million at March 31, 2008, and $129.3 million at December 31, 2008, primarily from decreased bookings of new units for the energy-related and marine markets.

Gross margin for the Power Transmission segment decreased to 26.2% for the three months ended March 31, 2009, compared to 30.3% for the three months ended March 31, 2008, or 4.1 percentage points. This gross margin decrease was primarily from the unfavorable mix effect of increased marine unit sales and increased material costs.

Direct selling, general and administrative expenses for Power Transmission increased to $5.5 million, or 4.8%, for the three months ended March 31, 2009, from $5.3 million for the three months ended March 31, 2008. This increase was due to higher employee-related expenses in support of increased sales in 2008. Direct selling, general and administrative expenses as a percentage of sales increased to 13.4% for the three months ended March 31, 2009, from 13.2% for the three months ended March 31, 2008.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on historical third-party revenues, were $6.7 million for the three months ended March 31, 2009, an increase of $0.2 million or 3.0%, from $6.5 million for the three months ended March 31, 2008, primarily from increased professional service and legal fees.

Interest income, interest expense and other income and expense for the three months ended March 31, 2009, increased to $0.5 million of income compared to income of $0.2 million for the three months ended March 31, 2008, primarily due to interest income on tax refund payments.

Pension expense, which is reported as a reduction of cost of sales, increased to $2.2 million for the three months ended March 31, 2009, compared to pension income of $0.5 million for the three months ended March 31, 2008. This decrease was primarily due to lower expected returns on asset balances and the amortization of 2008 market losses.

The net tax rate for the three months ended March 31, 2009, was 31.5% compared to 35.0% for the three months ended March 31, 2008. The net tax rate in 2009 benefited from the settlement of the 2006 IRS tax audit and R&E tax credit estimate adjustments. The tax rate for the balance of 2009 is expected to be approximately 36.0%.

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

Liquidity and Capital Resources

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

The Company's cash balance totaled $92.5 million at March 31, 2009, compared to $107.8 million at December 31, 2008. For the three months ended March 31, 2009, net cash provided by operating activities was $42.2 million, net cash used in investing activities totaled $52.5 million and net cash used in financing activities amounted to $4.6 million. Significant components of cash provided by operating activities included net earnings from continuing operations, adjusted for non-cash expenses, of $14.8 million, a decrease in working capital of $27.5 million. This working capital decrease was primarily due to a reduction in receivables balances of $46.6 million due to sales volumes declines since the fourth quarter of 2008, partially offset by increased inventory balances of $11.4 million from long-lead time purchases made to support higher-planned sales volumes. Net cash used in investing activities included net capital expenditures totaling $7.0 million and the ILS acquisition totaling $45.5 million. Capital expenditures in the first three months of 2009 were primarily for manufacturing and service efficiency improvements and replacements in the Oil Field and Power Transmission segments. Capital expenditures for 2009 are projected to be approximately $30.0 million, primarily for the expansion of manufacturing and service capacity and equipment replacement for efficiency improvements in the Oil Field and Power Transmission segments and will be funded by operating cash flows. Additional strategic capital expenditures of $30.0 million may be authorized depending on market outlooks and available operating cash flows. Certain capital projects may be deferred or cancelled depending on changes in business conditions and related internal cash flow. Significant components of net cash used by financing activities included dividend payments of $3.7 million, or $0.25 per share and short-term debt repayments of $0.8 million.

The Company has a three-year credit facility with a domestic bank (the "Bank Facility") consisting of an unsecured revolving line of credit that provides up to $40.0 million of aggregate borrowing. This Bank Facility expires on December 31, 2010. Borrowings under the Bank Facility bear interest, at the Company's option, at either the greater of (i) the prime rate, (ii) the base CD rate plus an applicable margin or (iii) the Federal Funds Effective Rate plus an applicable margin or the London Interbank Offered Rate plus an applicable margin, depending on certain ratios as defined in the Bank Facility. As of March 31, 2009, no debt was outstanding under the Bank Facility and the Company was in compliance with all financial covenants under the terms of the Bank Facility. Deducting outstanding letters of credit of $14.5 million, $25.5 million of borrowing capacity was available at March 31, 2009.

The Company assumed various notes payable and entered into purchase price hold back agreements in conjunction with the ILS acquisition in the first quarter of 2009. These obligations will require principal payments of $0.9 million during the last nine months of 2009.

Recently Issued Accounting Pronouncements

In December 2008, the Financial Accounting Standards Board issued Financial Statement Position No. FAS 132(R)-1 "Employer's Disclosures about Postretirement Benefit Plan Assets" ("FSP 132(R)-1"), which amends Statement of Financial Accounting Standards No. 132 (revised 2003) "Employer's Disclosures about Pensions and Other Postretirement Benefits" ("SFAS 132(R)). FSP 132(R)-1 expands the disclosure requirements about postretirement plan assets to include how investment allocations are made, including the factors that are pertinent to an understanding of investment policies and strategies, the major categories of plan assets, the input and valuation techniques used to measure the fair value of plan assets, the effect of fair value measurements using significant unobservable inputs (Level 3) on changes in plan assets for the periods and significant concentration of risk with plan assets. The disclosures about plan assets required by FSP 132(R)-1 shall be provided for fiscal years ending after December 15, 2009. Upon initial application, the provisions of FSP 132(R)-1 are not required for earlier periods that are presented for comparative purposes.

Management believes the impact of other recently issued standards, which are not yet effective, will not have a material impact on the Company's consolidated financial statements upon adoption.

Critical Accounting Policies and Estimates

The discussion and analysis of financial condition and results of operations are based upon the Company's consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosure of contingent assets and liabilities. The Company evaluates its estimates on an ongoing basis, based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. The Company believes the following critical accounting policies affect its more significant judgments and estimates used in preparation of its consolidated statements.

The Company extends credit to customers in the normal course of business. Management performs ongoing credit evaluations of our customers and adjusts credit limits based upon payment history and the customer's current credit worthiness. An allowance for doubtful accounts has been established to provide for estimated losses on receivable collections. The balance of this allowance is determined by regular reviews of outstanding receivables and historical experience. As the financial condition of customers change, circumstances develop or additional information becomes available, adjustments to the allowance for doubtful accounts may be required.

Revenue is not recognized until it is realized or realizable and earned. The criteria to meet this guideline are: persuasive evidence of an arrangement exists, delivery has occurred or services have been rendered, the price to the buyer is fixed or determinable and collectibility is reasonably assured. In some cases, a customer is not able to take delivery of a completed product and requests that the Company store the product for defined period of time. The Company will process a Bill-and-Hold invoice and recognize revenue at the time of the storage request if all of the following criteria are met:

l The customer has accepted title and risk of loss; l The customer has provided a written purchase order for the product; The customer, not the Company, requested the product to be stored and to be l invoiced under a Bill-and-Hold arrangement. The customer must also provide the business purpose for the storage request; l The customer must provide a storage period and future shipping date; The Company must not have retained any future performance obligations on the l product;
The Company must segregate the stored product and not make it available to use l on other orders; and
l The product must be completed and ready for shipment.

The Company has made significant investments in inventory to service its customers. On a routine basis, the Company uses estimates in determining the level of reserves required to state inventory at the lower of cost or market. Management's estimates are primarily influenced by market activity levels, production requirements, the physical condition of products and technological innovation. Changes in any of these factors may result in adjustments to the carrying value of inventory. Also, the Company accounts for a significant portion of its inventory under the LIFO method. The LIFO reserve can be impacted by changes in the LIFO layers and by inflation index adjustments. Generally, annual increases in the inflation rate or the FIFO value of inventory cause the value of the LIFO reserve to increase.

Long-lived assets held and used by the Company are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company assesses the recoverability of long-lived assets by determining whether the carrying value can be recovered through projected undiscounted cash flows, based on expected future operating results. Future adverse market conditions or poor operating results could result in the inability to recover the current carrying value and thereby possibly requiring an impairment charge in the future.

Goodwill acquired in connection with business combinations represent the excess of consideration over the fair value of net assets acquired. The Company performs impairment tests on the carrying value of goodwill at least annually or whenever events or changes in circumstances indicate the carrying value of goodwill may be greater than fair value, such as significant underperformance relative to historical or projected operating results and significant negative industry or economic trends. The Company's fair value is primarily determined using discounted cash flows, which requires management to make judgments about future operating results, working capital requirements and capital spending levels. Changes in cash flow assumptions or other factors which negatively impact the fair value of the operations would influence the evaluation and may result in a determination that goodwill is impaired and a corresponding impairment charge.

The Company adopted Financial Interpretation No. 48, "Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109", on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in accordance with Statement of Financial Accounting Standard No. 109, Accounting for Income Taxes, by prescribing a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The application of income tax law is inherently complex. The Company is required to determine if an income tax position meets the criteria of more-likely-than-not to be realized based on the merits of the position under tax laws, in order to recognize an income tax benefit. This requires the Company to make many assumptions and judgments regarding merits of income tax positions and the application of income tax law. Additionally, if a tax position meets the recognition criteria of more-likely-than-not the Company is required to make judgments and assumptions to measure the amount of the tax benefits to recognize based on the probability of the amount of tax benefits that would be realized if the tax position was challenged by the taxing authorities. Interpretations and guidance surrounding income tax laws and regulations change over time. As a consequence, changes in assumptions and judgments can materially affect amounts recognized in the consolidated financial statements.

Deferred tax assets and liabilities are recognized for the differences between . . .