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. Also, on July 1, 2009, the Company purchased Rotating Machinery Technology, Inc. (RMT), which specializes in the analysis, design and manufacture of precision, custom-engineered tilting-pad bearings and related components for high-speed turbo equipment operating in critical duty applications. RMT also services, repairs and upgrades turbo-expander process units for air and gas separation, both on-site with its skilled field service team and at its repair facility in Wellsville, New York.

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 into the first quarter of 2009 and worsened during the second 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. While oil prices increased during the second quarter of 2009, demand levels will not increase until customers are confident these higher prices will be maintained. Demand for new equipment in North America during the second half of 2009 will also be negatively impacted by customer inventory of new pumping unit equipment ordered in late in 2008 or early 2009 unless oil drilling activity increases over the current levels. 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. While booking levels in the second quarter of 2009 improved over the first quarter of 2009, overall booking levels are below the 2008 run-rate. 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 second quarter of 2009, the Company recorded an additional contingent liability provision of $2.0 million (pre-tax) related to its ongoing class-action lawsuit. The total contingency recorded during the first six months of 2009 now totals $5.0 million (pre-tax). 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.

Overall, sales for the three months ended June 30, 2009, decreased to $123.7 million from $174.5 million for the three months ended June 30, 2008, or 29.1%, and sales for the six months ended June 30, 2009, decreased to $276.9 million from $315.6 million for the six months ended June 30, 2008. This decrease was primarily driven by lower sales of oil field products and services in the North American market, partially offset by continued growth in power transmission sales.

Gross margin for the three months ended June 30, 2009, decreased to 21.8% from 27.4% for the three months ended June 30, 2008, and gross margin for the six months ended June 30, 2009, decreased to 22.1% from 28.0% for the six months ended June 30, 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 $18.6 million during the second quarter of 2009 from $17.0 million during the second quarter of 2008, and increasing to $37.0 million during the first half of 2009 from $33.7 million during the first half of 2008. This increase was primarily related to higher divisional spending to support higher sales volume in 2008. As a percentage of sales, selling, general and administrative expenses also increased to 15.0% for the three months ended June 30, 2009, from 9.7% in the three months ended June 30, 2008, and increased to 13.4% for the six months ended June 30, 2009, from 10.7% for the six months ended June 30, 2008. The Company has made the strategic decision to maintain employment levels in this area to focus on new product and geographic expansion opportunities. Operating income was also impacted by a litigation reserve of $2.0 million during the three months ended June 30, 2009, and $5.0 million during the six months ended June 30, 2009, related to its ongoing class-action lawsuit.

The Company reported net earnings from continuing operations of $4.7 million or $0.32 per share (diluted) for the three months ended June 30, 2009, compared to net earnings from continuing operations of $21.2 million or $1.44 per share (diluted) for the three months ended June 30, 2008. Net earnings from continuing operations were $13.8 million or $0.93 per share (diluted) for the six months ended June 30, 2009, compared to net earnings from continuing operations of $36.7 million or $2.47 per share (diluted) for the six months ended June 30, 2008

Debt/equity (long-term debt net of current portion as a percentage of total equity) levels were 0.6% as of June 30, 2009, and 0.0% at December 31, 2008. Cash balances at June 30, 2009, were $86.3 million, down from $107.8 million at December 31, 2008.

Three Months Ended June 30, 2009, Compared to Three Months Ended June 30, 2008

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

                               Three Months Ended
                                    June 30,              Increase/       % Increase/
                               2009          2008        (Decrease)       (Decrease)
        Sales
        Oil Field            $  74,994     $ 126,507     $   (51,513 )           (40.7 )
        Power Transmission      48,745        47,981             764               1.6
        Total                $ 123,739     $ 174,488     $   (50,749 )           (29.1 )

        Gross Profit
        Oil Field            $  12,872     $  33,026     $   (20,154 )           (61.0 )
        Power Transmission      14,124        14,756            (632 )            (4.3 )
        Adjustment*                  -            13             (13 )          (100.0 )
        Total                $  26,996     $  47,795     $   (20,799 )           (43.5 )

* 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 decreased to $75.0 million, or 40.7%, for the three months ended June 30, 2009, from $126.5 million for the three months ended June 30, 2008. New unit sales of $38.6 million during the second quarter of 2009 were down $40.6 million, or 51.3%, compared to $79.2 million during the second quarter 2008, primarily from lower U.S. demand and pricing pressure. Pumping unit service sales of $19.4 million during the second quarter of 2009 were down $4.6 million, or 19.1%, compared to $24.0 million during the second quarter of 2008, from declines in the U.S. market. Automation sales of $11.0 million during the second quarter of 2009 were down $6.6 million, or 37.6%, compared to $17.6 million during the second quarter 2008, from lower sales in the U.S and pricing pressure. Commercial casting sales of $1.8 million during the second quarter of 2009 were down $3.9 million, or 68.7%, compared to $5.8 million during the second quarter 2008, from lower sales to the machine tool market. Sales from Lufkin ILS contributed $4.2 million during the second quarter of 2009. Oil Field's backlog decreased to $53.1 million as of June 30, 2009, from $170.9 million at June 30, 2008, and $188.1 million at December 31, 2008. This decrease was caused primarily by lower orders for new pumping units as U.S. and international 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 17.2% for three months ended June 30, 2009, compared to 26.1% for the three months ended June 30, 2008, or 8.9 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 $6.7 million, or 26.8%, for the three months ended June 30, 2009, from $5.3 million for the three months ended June 30, 2008. The majority of this increase is related to the resources added with the ILS acquisition. Direct selling, general and administrative expenses as a percentage of sales increased to 8.9% for the three months ended June 30, 2009, from 4.2% for the three months ended June 30, 2008.

Power Transmission

Sales for the Company's Power Transmission segment increased to $48.7 million, or 1.6%, for the three months ended June 30, 2009, compared to $48.0 million for the three months ended June 30, 2008. New unit sales of $38.1 million during the second quarter of 2009 were up $1.0 million, or 2.6%, compared to $37.1 million during the second quarter of 2008 from increased sales of high-speed units to the oil and gas markets. Repair and service sales of $10.7 million during the second quarter of 2009 were down $0.1 million, or 1.7%, compared to $10.8 million during the second quarter 2008. Power Transmission backlog at June 30, 2009, decreased to $109.1 million from $138.8 million at June 30, 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 29.0% for the three months ended June 30, 2009, compared to 30.8% for the three months ended June 30, 2008, or 1.8 percentage points. This gross margin decrease was primarily from the unfavorable impact of lower production levels in manufacturing and repair on fixed cost coverage. While new unit sales were greater in the second quarter of 2009 compared to the second quarter of 2008, lean manufacturing efforts in the second quarter of 2009 reduced the level of work-in-process in the U.S. manufacturing facility.

Direct selling, general and administrative expenses for Power Transmission decreased to $5.8 million, or 1.4%, for the three months ended June 30, 2009, from $5.9 million for the three months ended June 30, 2008. Direct selling, general and administrative expenses as a percentage of sales also decreased to 12.0% for the three months ended June 30, 2009, from 12.3% for the three months ended June 30, 2008.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on historical third-party revenues, were $6.0 million for the three months ended June 30, 2009, an increase of $0.3 million or 5.1%, from $5.7 million for the three months ended June 30, 2008, primarily from increased professional service and legal fees.

Interest income, interest expense and other income and expense for the three months ended June 30, 2009, remained at $0.7 million of income compared to the three months ended June 30, 2008, from currency gains offsetting reduced interest income.

Pension expense, which is reported as an increase in cost of sales, increased to $2.9 million for the three months ended June 30, 2009, compared to pension income of $0.6 million for the three months ended June 30, 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 June 30, 2009, was 33.1% compared to 32.8% for the three months ended June 30, 2008. The net tax rate in the second quarter of 2009 benefitted from adjustments to prior period tax filings in the U.S. from recent IRS rule changes. 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.

Six Months Ended June 30, 2009, Compared to Six Months Ended June 30, 2008

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

                                Six Months Ended
                                    June 30,              Increase/       % Increase/
                               2009          2008        (Decrease)       (Decrease)
        Sales
        Oil Field            $ 186,677     $ 227,416     $   (40,739 )           (17.9 )
        Power Transmission      90,200        88,142           2,058               2.3
        Total                $ 276,877     $ 315,558     $   (38,681 )           (12.3 )

        Gross Profit
        Oil Field            $  36,201     $  61,257     $   (25,056 )           (40.9 )
        Power Transmission      24,978        26,943          (1,965 )            (7.3 )
        Adjustment*                  -           115            (115 )          (100.0 )
        Total                $  61,179     $  88,315     $   (27,136 )           (30.7 )

* 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 decreased to $186.7 million, or 17.9%, for the six months ended June 30, 2009, from $227.4 million for the six months ended June 30, 2008. New unit sales of $107.3 million during the first half of 2009 were down $27.6 million, or 20.4%, compared to $134.9 million during the first half 2008, primarily from lower U.S. demand and pricing pressure. Pumping unit service sales of $41.4 million during the first half of 2009 were down $3.6 million, or 8.0%, compared to $45.0 million during the first half of 2008, from declines in the U.S. market. Automation sales of $26.6 million during the first half of 2009 were down $9.4 million, or 26.0%, compared to $35.9 million during the first half 2008, from lower sales in the U.S and pricing pressure. Commercial casting sales of $5.2 million during the first half of 2009 were down $6.4 million, or 55.4%, compared to $11.6 million during the first half 2008, from lower sales to the machine tool market. Sales from Lufkin ILS contributed $6.2 million during the first half of 2009. Oil Field's backlog decreased to $53.1 million as of June 30, 2009, from $188.1 million at December 31, 2008. This decrease was caused primarily by lower orders for new pumping units as U.S. and international 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 19.4% for six months ended June 30, 2009, compared to 26.9% for the six months ended June 30, 2008, or 7.5 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 $12.9 million, or 25.7%, for the six months ended June 30, 2009, from $10.3 million for the six months ended June 30, 2008. The majority of this increase is related to personnel added to support higher sales volume in the latter part of 2008 as well as the resources added with the ILS acquisition. Direct selling, general and administrative expenses as a percentage of sales increased to 6.9% for the six months ended June 30, 2009, from 4.5% for the six months ended June 30, 2008.

Power Transmission

Sales for the Company's Power Transmission segment increased to $90.2 million, or 2.3%, for the six months ended June 30, 2009, compared to $88.1 million for the six months ended June 30, 2008. New unit sales of $70.9 million during the first half of 2009 were up $2.3 million, or 3.3%, compared to $68.7 million during the first half of 2008 from increased sales of high-speed units to the oil and gas markets. Repair and service sales of $19.3 million during the first half of 2009 were down $0.2 million, or 1.0%, compared to $19.5 million during the first half 2008. Power Transmission backlog at June 30, 2009, decreased to $109.1 million from $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 27.7% for the six months ended June 30, 2009, compared to 30.6% for the six months ended June 30, 2008, or 2.9 percentage points. This gross margin decrease was primarily from the unfavorable impact of lower production levels in manufacturing and repair on fixed cost coverage. While new unit sales were greater in the first half of 2009 compared to the first half of 2008, lean manufacturing efforts in the second quarter of 2009 reduced the level of work-in-process in the U.S. manufacturing facility.

Direct selling, general and administrative expenses for Power Transmission increased to $11.4 million, or 1.5%, for the six months ended June 30, 2009, from $11.2 million for the six months ended June 30, 2008. Direct selling, general and administrative expenses as a percentage of sales decreased to 12.6% for the six months ended June 30, 2009, from 12.7% for the six months ended June 30, 2008.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on historical third-party revenues, were $12.7 million for the six months ended June 30, 2009, an increase of $0.5 million or 4.0%, from $12.3 million for the six months ended June 30, 2008, primarily from increased professional service and legal fees.

Interest income, interest expense and other income and expense for the six months ended June 30, 2009, increased to $1.2 million of income compared to $0.9 million for the six months ended June 30, 2008, from currency gains offsetting reduced interest income.

Pension expense, which is reported as an increase in cost of sales, increased to $5.1 million for the six months ended June 30, 2009, compared to pension income of $1.1 million for the six months ended June 30, 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 six months ended June 30, 2009, was 32.1% compared to 33.8% for the six months ended June 30, 2008. The net tax rate in the first half of 2009 benefitted from adjustments to prior period tax filings in the U.S. from recent IRS rule changes, 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 $86.3 million at June 30, 2009, compared to $107.8 million at December 31, 2008. For the six months ended June 30, 2009, net cash provided by operating activities was $50.0 million, net cash used in investing activities totaled $62.7 million and net cash used in financing activities amounted to $8.6 million. Significant components of cash provided by operating activities included net earnings from continuing operations, adjusted for non-cash expenses, of $27.3 million and a decrease in working capital of $22.7 million. This working capital decrease was primarily due to a reduction in receivables balances of $55.5 million due to sales volumes declines since the fourth quarter of 2008, partially offset by increased inventory balances of $7.6 million from long-lead time purchases made to support higher-planned sales volumes and reductions in accounts payable and accrued liabilities of $37.9 million. Net cash used in investing activities included net capital expenditures totaling $16.7 million and the ILS acquisition totaling $45.5 million. Capital expenditures in the first six months of 2009 were primarily for new facilities to support geographical and product line expansions in the Oil Field and Power Transmission segments. Capital expenditures for 2009 are projected to be approximately $45.0 to $50.0 million, primarily for the new facilities to support geographical and product line expansions and equipment replacement for efficiency improvements in the Oil Field and Power Transmission segments and will be funded by operating cash flows. Certain capital projects may be deferred or cancelled depending on changes in business conditions and related internal . . .