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, develop new product lines and reduce manufacturing lead times, in addition to certain capital investments targeting cost reductions. 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 is primarily dependent on the level of new onshore oil wells, workover drilling activity, the depth and fluid conditions of such drilling activity 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 as well as a partial recapture of market share from imported equipment domestically.

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 starting to be reflected in international markets. 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 continued to increase during the third quarter of 2009, demand levels did not change significantly over the second quarter of 2009 and will not increase until customers are confident these higher prices will be maintained. Demand for new equipment in North America during the fourth quarter of 2009 will continue to 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 net bookings were up 62% in Oil Field during the third quarter of 2009 compared to the second quarter of 2009, second quarter bookings were negatively impacted by cancellation of orders originally placed in late 2008.

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. This was reflected in lower bookings in the third quarter of 2009 as compared to the second quarter of 2009. 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 half of 2009, the Company recorded an additional contingent liability provision of $5.0 million (pre-tax) related to our ongoing class-action lawsuit. No provisions were recorded during the third quarter of 2009. See Part II, Item 1. "Legal Proceedings" 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 September 30, 2009, decreased to $117.7 million from $195.1 million for the three months ended September 30, 2008, or 39.7%, and sales for the nine months ended September 30, 2009, decreased to $394.6 million from $510.6 million for the nine months ended September 30, 2008, or 22.7%. This decrease was primarily driven by lower sales of oil field products and services in the North American market.

Gross margin for the three months ended September 30, 2009, decreased to 21.2% from 28.6% for the three months ended September 30, 2008, and gross margin for the nine months ended September 30, 2009, decreased to 21.8% from 28.2% for the nine months ended September 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 $17.8 million during the third quarter of 2009 from $17.0 million during the third quarter of 2008, and increasing to $54.8 million during the first nine months of 2009 from $50.7 million during the first nine months of 2008. This increase was primarily related to resources added from the ILS and RMT acquisitions. As a percentage of sales, selling, general and administrative expenses also increased to 15.1% for the three months ended September 30, 2009, from 8.7% in the three months ended September 30, 2008, and increased to 13.9% for the nine months ended September 30, 2009, from 9.9% for the nine months ended September 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 $5.0 million during the nine months ended September 30, 2009, related to its ongoing class-action lawsuit.

The Company reported net earnings from continuing operations of $5.1 million or $0.34 per share (diluted) for the three months ended September 30, 2009, compared to net earnings from continuing operations of $25.0 million or $1.66 per share (diluted) for the three months ended September 30, 2008. Net earnings from continuing operations were $18.9 million or $1.27 per share (diluted) for the nine months ended September 30, 2009, compared to net earnings from continuing operations of $61.7 million or $4.14 per share (diluted) for the nine months ended September 30, 2008.

Debt/equity (long-term debt net of current portion as a percentage of total equity) levels were 0.5% as of September 30, 2009, and 0.0% at December 31, 2008. Cash balances at September 30, 2009, were $102.2 million, down from $107.8 million at December 31, 2008.

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

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

                               Three Months Ended
                                  September 30,           Increase/       % Increase/
                               2009          2008        (Decrease)       (Decrease)
        Sales
        Oil Field            $  73,732     $ 147,073     $   (73,341 )           (49.9 )
        Power Transmission      43,956        48,017          (4,061 )            (8.5 )
        Total                $ 117,688     $ 195,090     $   (77,402 )           (39.7 )

        Gross Profit
        Oil Field            $  11,054     $  41,232     $   (30,178 )           (73.2 )
        Power Transmission      13,878        14,590            (712 )            (4.9 )
        Total                $  24,932     $  55,822     $   (30,890 )           (55.3 )

Oil Field

Oil Field sales decreased to $73.7 million, or 49.9%, for the three months ended September 30, 2009, from $147.1 million for the three months ended September 30, 2008. New unit sales of $37.3 million during the third quarter of 2009 were down $55.6 million, or 59.9%, compared to $92.9 million during the third quarter of 2008, primarily from lower U.S. demand and pricing pressure. Pumping unit service sales of $19.9 million during the third quarter of 2009 were down $7.6 million, or 27.6%, compared to $27.4 million during the third quarter of 2008, from declines in the U.S. market due to demand and pricing pressure. Automation sales of $9.8 million during the third quarter of 2009 were down $9.3 million, or 48.6%, compared to $19.2 million during the third quarter of 2008, from lower sales in the U.S and pricing pressure. Commercial casting sales of $2.0 million during the third quarter of 2009 were down $5.5 million, or 72.8%, compared to $7.5 million during the third quarter 2008, from lower sales to the machine tool market. Sales from Lufkin ILS contributed $4.7 million during the third quarter of 2009. Oil Field's backlog decreased to $35.9 million as of September 30, 2009, from $279.8 million at September 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 15.0% for three months ended September 30, 2009, compared to 28.0% for the three months ended September 30, 2008, or 13.0 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 26.3%, for the three months ended September 30, 2009, from $4.9 million for the three months ended September 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 8.5% for the three months ended September 30, 2009, from 3.4% for the three months ended September 30, 2008.

Power Transmission

Sales for the Company's Power Transmission segment decreased to $44.0 million, or 8.5%, for the three months ended September 30, 2009, compared to $48.0 million for the three months ended September 30, 2008. New unit sales of $34.0 million during the third quarter of 2009 were down $2.0 million, or 5.5%, compared to $36.0 million during the third quarter of 2008 from decreased sales of low-speed units to the industrial and marine markets. Repair and service sales of $9.1 million during the third quarter of 2009 were down $3.0 million, or 24.5%, compared to $12.1 million during the third quarter 2008 as customers deferred spending on maintenance projects due to poor economic conditions. Sales from Lufkin RMT contributed $0.9 million during the third quarter of 2009. Power Transmission backlog at September 30, 2009, decreased to $97.9 million from $134.1 million at September 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 increased to 31.6% for the three months ended September 30, 2009, compared to 30.4% for the three months ended September 30, 2008, or 1.2 percentage points. This gross margin increase was primarily from the favorable mix effect of increased sales of high-speed units from marine units and repair work.

Direct selling, general and administrative expenses for Power Transmission increased to $5.9 million, or 7.7%, for the three months ended September 30, 2009, from $5.5 million for the three months ended September 30, 2008. The majority of this increase is related to the resources added with the RMT acquisition. Direct selling, general and administrative expenses as a percentage of sales also increased to 13.5% for the three months ended September 30, 2009, from 11.5% for the three months ended September 30, 2008.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on budgeted sales levels, were $5.6 million for the three months ended September 30, 2009, a decrease of $1.0 million or 14.6%, from $6.5 million for the three months ended September 30, 2008, primarily from decreased personnel-related expenses.

Interest income, interest expense and other income and expense for the three months ended September 30, 2009, increased to $0.5 million of income compared to $0.1 million of income for the three months ended September 30, 2008, from currency gains offsetting reduced interest income.

Pension expense, which is reported as an increase in cost of sales, increased to $2.5 million for the three months ended September 30, 2009, compared to pension income of $0.5 million for the three months ended September 30, 2008. This increase in expense 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 September 30, 2009, was 33.9% compared to 35.8% for the three months ended September 30, 2008. The net tax rate in the third quarter of 2009 benefitted from adjustments to prior period tax filings in the U.S. The tax rate for the balance of 2009 is expected to be approximately 36.0%.

Nine Months Ended September 30, 2009, Compared to Nine Months Ended September 30, 2008

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

                                Nine Months Ended
                                  September 30,           Increase/       % Increase/
                               2009          2008        (Decrease)       (Decrease)
        Sales
        Oil Field            $ 260,408     $ 374,489     $  (114,081 )           (30.5 )
        Power Transmission     134,157       136,159          (2,002 )            (1.5 )
        Total                $ 394,565     $ 510,648     $  (116,083 )           (22.7 )

        Gross Profit
        Oil Field            $  47,255     $ 102,488     $   (55,233 )           (53.9 )
        Power Transmission      38,856        41,534          (2,678 )            (6.4 )
        Adjustment*                  -           115            (115 )          (100.0 )
        Total                $  86,111     $ 144,137     $   (58,026 )           (40.3 )

* 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 $260.4 million, or 30.5%, for the nine months ended September 30, 2009, from $374.5 million for the nine months ended September 30, 2008. New unit sales of $144.6 million during the first nine months of 2009 were down $83.2 million, or 36.5%, compared to $227.8 million during the first nine months 2008, primarily from lower U.S. demand and pricing pressure. Pumping unit service sales of $61.2 million during the first nine months of 2009 were down $11.2 million, or 15.4%, compared to $72.4 million during the first nine months of 2008, from declines in the U.S. market. Automation sales of $36.4 million during the first nine months of 2009 were down $18.7 million, or 33.9%, compared to $55.1 million during the first nine months 2008, from lower sales in the U.S and pricing pressure. Commercial casting sales of $7.2 million during the first nine months of 2009 were down $11.9 million, or 62.3%, compared to $19.1 million during the first nine months 2008, from lower sales to the machine tool market. Sales from Lufkin ILS contributed $10.9 million during the first nine months of 2009. Oil Field's backlog decreased to $35.9 million as of September 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 18.1% for nine months ended September 30, 2009, compared to 27.4% for the nine months ended September 30, 2008, or 9.3 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 $19.1 million, or 25.9%, for the nine months ended September 30, 2009, from $15.2 million for the nine months ended September 30, 2008. The majority of this increase is related to higher international sales commissions as well as the resources added with the ILS acquisition. Direct selling, general and administrative expenses as a percentage of sales increased to 7.3% for the nine months ended September 30, 2009, from 4.1% for the nine months ended September 30, 2008.

Power Transmission

Sales for the Company's Power Transmission segment decreased to $134.2 million, or 1.5%, for the nine months ended September 30, 2009, compared to $136.2 million for the nine months ended September 30, 2008. New unit sales of $104.9 million during the first nine months of 2009 were up $0.3 million, or 0.3%, compared to $104.6 million during the first nine months of 2008. Repair and service sales of $28.3 million during the first nine months of 2009 were down $3.2 million, or 10.0%, compared to $31.5 million during the first nine months 2008 as customers deferred spending on maintenance projects due to poor economic conditions. Sales from Lufkin RMT contributed $0.9 million during the first nine months of 2009. Power Transmission backlog at September 30, 2009, decreased to $97.9 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 29.0% for the nine months ended September 30, 2009, compared to 30.5% for the nine months ended September 30, 2008, or 1.5 percentage points. This gross margin decrease was primarily from the unfavorable impact of lower production levels in manufacturing and repair on fixed cost coverage.

Direct selling, general and administrative expenses for Power Transmission increased to $17.3 million, or 3.5%, for the nine months ended September 30, 2009, from $16.7 million for the nine months ended September 30, 2008. Direct selling, general and administrative expenses as a percentage of sales increased to 12.9% for the nine months ended September 30, 2009, from 12.3% for the nine months ended September 30, 2008.

Corporate/Other

Corporate administrative expenses, which are allocated to the segments primarily based on budgeted sales levels, were $18.3 million for the nine months ended September 30, 2009, a decrease of $0.5 million or 2.5%, from $18.8 million for the nine months ended September 30, 2008.

Interest income, interest expense and other income and expense for the nine months ended September 30, 2009, increased to $1.7 million of income compared to $1.0 million of income for the nine months ended September 30, 2008, from currency gains offsetting reduced interest income.

Pension expense, which is reported as an increase in cost of sales, increased to $7.6 million for the nine months ended September 30, 2009, compared to pension income of $1.6 million for the nine months ended September 30, 2008. This expense increase was primarily due to lower expected returns on asset balances and the amortization of 2008 market losses.

The net tax rate for the nine months ended September 30, 2009, was 32.6% compared to 34.6% for the nine months ended September 30, 2008. The net tax rate in the first nine months of 2009 benefitted from adjustments to prior period tax filings in the U.S., 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 $102.2 million at September 30, 2009, compared to $107.8 million at December 31, 2008. For the nine months ended September 30, 2009, net cash provided by operating activities was $87.8 million, net cash used in investing activities totaled $79.7 million and net cash used in financing activities amounted to $14.1 million. Significant components of cash provided by operating activities included net earnings from continuing operations, adjusted for non-cash expenses, of $37.6 million and a decrease in working capital of $49.8 million. This working capital decrease was primarily due to a reduction in trade receivables balances of $65.1 million and inventory balances of $20.3 million due to sales volumes declines since the fourth quarter of 2008, partially offset by reductions in accounts payable and accrued liabilities of $33.5 million. Net cash used in investing activities included net capital expenditures totaling $26.9 million and the ILS and RMT acquisitions totaling $51.7 million. Capital expenditures in the first nine 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 $40.0 to $45.0 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. Significant components of net cash used by financing activities included dividend payments of $11.1 million, or $0.75, per share and debt repayments of $3.0 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 . . .